A Letter of Credit (LOC) is a document stating the commitment on the part of a bank to place an agreed upon sum of money at the disposal of a beneficiary on behalf of a client/counterparty under precisely defined conditions.
| An LOC is issued in order to facilitate a transaction between a buyer and a seller that are unknown to each other and are seeking some sort of performance and payment guarantee from well-known banks.|
Advising bank: The bank (usually the seller's bank) receiving a letter of credit from the issuing bank (the buyer's bank) and handling the transaction from the seller's side. This includes validating the letter of credit, reviewing it for internal consistency, forwarding it to the seller, forwarding seller's documentation back to the issuing bank, and, in the case of a confirmed letter of credit, guaranteeing payment to the seller if documents are in order and the terms of the credit are met.
Beneficiary: the individual or company in whose favor a letter of credit is opened.
Drawee: The buyer in a documentary collection.
Types of LOCs
Sight or Term (documentary)
Back to Back
Irrevocable credit: A letter of credit that cannot be revoked or amended without prior mutual consent of the seller, the buyer, and all intermediaries. The Issuing Bank must follow through with payment to the seller so long as the seller complies with the conditions listed in the credit. Changes in the credit must be approved by both the buyer and the seller. This is the most common form of credit used in international trade. There are two forms of irrevocable credits:
Unconfirmed credit (the irrevocable credit not confirmed by the advising bank): In an unconfirmed credit the buyer's bank issuing the credit is the only party responsible for payment to the seller. The seller's bank is obliged to pay only after the payment from the buyer's bank is received. The seller's bank merely acts on behalf of the issuing bank and therefore incurs no risk.
Confirmed credit (the irrevocable, confirmed credit): In a confirmed credit, the advising bank adds its guarantee to pay the seller to that of the buyer's (issuing) bank. If the buyer's bank fails to make payment, the seller's bank will pay. If a seller is unfamiliar with the buyer's bank issuing the letter of credit, an irrevocable, confirmed credit may be insisted upon. These credits may be used when trade is conducted in a high-risk area where there are fears of war or social, political, or financial instability. Confirmed credits may also be used by the seller to enlist the aid of a local bank to extend financing to help an order be filled. A confirmed credit costs more because the bank has added liability.
Issuing bank: The buyer's bank which establishes a letter of credit in favor of the seller, or beneficiary (the entity to which credits and payments are made, usually the seller/supplier).
Revocable letter of credit: A letter of credit which may be revoked or amended by the issuer (buyer) without prior notice to other parties in the letter of credit process. It is rarely used and is usually unacceptable to the Seller.
Standby Letter of Credit: This credit is basically a payment or performance guarantee used primarily in the United States. They are often called non-performing letters of credit because they are only used as a backup payment if the collection on a primary payment method is past due. Standby letters of credit can be used, for example, to guarantee repayment of loans, fulfillment by subcontractors, and securing the payment for goods delivered by third parties. The beneficiary to a standby letter of credit can draw from it on demand, so the buyer assumes added risk.Forward Contract
A Forward contract is considered a derivative product as the contract has no intrinsic value other than that which can be derived from the cash value or income stream value of an underlying asset.
Forward Market: Over the counter market for future delivery or, in physical commodities, for later shipment. In the USA it can also mean trading outside a commodities exchange for delivery at a future date.
Forward contracts can be considered a customized futures contract. A forward is an agreement between two parties to buy or sell a commodity or asset at a specific future time for an agreed upon price. Typically, the contract is between a producer and a merchant; a dealer and an end user; two financial institutions; or a financial institution and a client. As the forward contract is not exchange traded it is also more flexible than a futures contract: the two parties may define their own delivery date, underlying contract amount, etc.
Forward contracts are not Exchange traded and each party is responsible for the credit worthiness of the counterparty.
Types of Forward Contracts
Commodity Non Deliverable Forward is a forward contract that will be closed out and cash settled. The close out price can be based on an average price or can be negotiated between counterparties.
Forward Rate Agreements (FRAs)
An over the counter, cash settled forward contract on interest rates, usually LIBOR (sort of the OTC equivalent of a Eurodollar futures contract).
Confirmed agreement between two parties to exchange an interest rate differential on a notional principal amount at a given future date.
A contract that fixes the interest now that will apply to a loan or deposit for a particular amount for a given period starting on a certain date in the future (the settlement date).
FRA maturities usually correspond to Eurodollar time deposit maturities.
The Seller of an FRA agrees to pay the Buyer the increased interest expense if the contract referenced LIBOR maturity interest rate is higher than the contract stipulated Forward rate (on the Settlement date / contract maturity). The principal amount is always referred to as the Notional amount.
The Buyer of an FRA agrees to pay the Seller the decreased interest expense if the contract referenced LIBOR maturity interest rate is lower than the contract stipulated Forward rate (on the Settlement date / contract maturity). The principal amount is always referred to as the Notional amount.
On the settlement date no actual principal is exchanged. Rather, the buyer and the seller calculate the present value of the net interest owed, and one party makes a cash settlement payment.
The formula for determining the payment is:
Payment = (N) (LIBOR - FR) (dtm / 360) / 1 + LIBOR (dtm / 360)
(N = Notional Principal Amount) (LIBOR = LIBOR value on Settlement Date for the maturity specified by the contract) (FR = Forward Rate specified by the contract) (dtm = Days to Maturity of the Forward Rate)
Notional Amount of Principal: USD10,000,000
Settlement in One Month
Forward Rate of 4% (four percent) on a Eurodollar Deposit, 90-days (three months)
Actual 3-month LIBOR rate of 5% (five percent) on the contract Settlement Date
As the LIBOR rate is higher than specified in the contract, Seller of the FRA owes the Buyer the difference between the 5% and the 4% interest on the Notional Amount for 90 days.
Payment = (10,000,000) (.05 - .04) (90 / 360) / 1 + 0.05 (90 / 360)
Payment = (100,000) (.25) / 1 + 0.0125
Payment = 25,000 / 1.0125
Payment = $24,691.36
Forward Gold Market
A mine may know that they will produce a certain tonnage in the next six months. They could enter into a forward agreement to sell this gold when it became available. Thus, the company will lock in the present gold price and hedge a decline in the price, and know what their income would be when planning production.
Unlike a bond or a share, gold pays no interest or dividends. Starting from a neutral position the trader buys gold intending to sell it in one month. To buy the gold the trader has to borrow U.S. dollars (gold is quoted in dollars). When he sells the gold at the end of the month, he repays the loan, but he will be out of pocket to the extent of the interest charged on the loan. The price which he sells the gold at the end of the month must therefore be higher than the price paid for it to compensate the trader for the "cost of carry" which he has paid. That is why the forward price is usually higher than the spot price (premium).
Leasing is very popular as it allows a company to keep from having to report the lease obligation of its balance sheet, although the company is contractually responsible for monthly payments similar to a debt instrument. This allows a company to show an improvement to return on assets and have lower depreciation (as the asset is not "owned" or reported but is providing income). Under FASB guidelines (Financial Accounting Standard No. 13), if the present value of an asset's minimum lease payment is equal to 90% or more of the asset's value then the lease must be treated as a "capital lease", which means that it must be reported on-balance sheet as similar to debt. If the payment is less than 90% then the lease is treated as an "operating lease", which means that it is not reported on-balance sheet. Additionally, a lease must be termed a capital lease if the term of the lease is equal to or longer than 75% of the useful life of the asset.
A synthetic lease means that a company guarantees a fixed percentage of the cost of an asset, retains operating control of the asset, is allowed the deduction for the interest expense for the cost of the asset, is allowed the deduction for the depreciation of the asset, however it is not rported on either the asset-side or the liability-side of the balance sheet.
Lessor: the owner of the asset.
Lessee: the one who is leasing the asset.
Closed-end Lease: the lessee is not responsible for the secondary market value of the asset at the end of the lease term. Since the Lessor assumes the risk for the secondary market value of the asset, lease payments will typically be higher than in an open-ended lease.
Direct Lease: An agreement in which a company or person borrows another party's real estate, equipment or other property for a specified time in exchange for payment.
Leveraged Lease: A specific form of lease involving at least three parties: a lessor, a lessee and a funding source. The lessor borrows a significant portion of the equipment cost on a nonrecourse basis by assigning the future lease payment stream to the lender in return for up-front funds (the borrowing). The lessor puts up a minimal amount of its own equity (the difference between the equipment cost and the present value of the assigned lease payments).
Open-ended Lease: the lessee assumes the responsibility for the secondary market value of the the asset at the end of the lease term. If the residual value was estimated inaccurately, the Lessee must pay either a portion or all of the short-fall to market value as an end of lease payment.
Operating Lease: the manufacturer has a vested interest in the recovery of the residual investment. They carry a significant investment risk since the recovery of the residual investment is dependent upon the equipment values and the position of the manufacturer; A lease agreement that meets certain established criteria and therefore is not required to be reported on the balance sheet. The lessor assumes any risk associated with the residual value.
Common Equipment Lease Types: The two most popular lease types are Finance Leases and True Leases.
Finance Leases generally call for the "Full-Pay-Out" of the total equipment cost and financing charges over the original lease term. These Leases ordinarily include a fixed Purchase Option (I.e. $1.00 or a fixed percentage of equipment cost.)
Since the end-of-term purchase price is predetermined; Finance Leases may not meet the requirements for tax deductibility or for "Off-Balance Sheet" accounting treatment.
True Leases do not call for full-pay-out of the equipment cost and financing charges during the original lease term. Typically, Lessees receive either no option or, at most, an FMV option to purchase the equipment.
Since True Leases intend to provide only equipment usage, and don't include predetermined Purchase Option prices, Lessees often classify True Lease payments as operating expenses, thereby gaining any available Tax Benefits.
Operating Leases: Some True Leases are known as "Operating Leases" because the Lessee can classify the lease payments as operating expenses on its "Income Statement". Truly leased equipment does not necessarily appear on the Lessee's "Balance Sheet" as an owned asset, nor do the corresponding lease payments appear on the Lessee's Balance Sheet as fixed debt.
Sale Lease back: Agreement in which a financial institution buys equipment from a company and leases it back to the company. This transaction allows a company to utilize the equipment without having to record any asset or liability on its balance sheet. The rentals payment schedule is carefully structured to equal a discounted cash flow that will approximate the amortized and depreciated disposable / salvage value of the asset at the end of the lease term.