Explain what a letter of credit (L/C) is, who the principle parties are, what the principle advantage is, and how the L/C facilitates international trade
What will be an ideal response?
Answer: A letter of credit (L/C) is a bank's conditional promise to pay issued by a bank at the request of an importer. The primary advantage of an L/C is the reduction in risk. This reduction in risk makes it easier for the exporter to sell goods to the importer because it no longer need rely on the ability of the importing firm to pay for the goods, but rather it can rely on the bank.
There are three primary parties involved with a letter of credit. Party number one is the exporter, who makes a sale to the importer in exchange for the bank's L/C. Party number two is the importer who receives the goods and promises to pay the bank. And third, the bank that contracts with the importer and agrees to pay the exporter upon presentation of documents as specified in the L/C.
The advantage to an exporter is the increased likelihood of receiving payment because funds are due from a known international commercial bank as opposed to a relatively unknown importer. Furthermore, an exporter with a good reputation for delivery may be able to sell the L/C at a discount in the secondary market prior to shipping and speed up cash flow.
The importer benefits because it doesn't need to pay for goods purchased until they actually reach port. The bank benefits from the fees they charge.
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