What is a Letter of Credit?

by Investing School on January 31, 2010

A letter of credit is a document that is issued usually by financial institutions and those institutions are primarily in trade finance. A letter of credit can also pay for a transaction. This means that presenting the letter of credit will allow payment to an exporter. Letters of credit are used commonly with international trade transactions of particularly high value. These deals usually happen with a supplier located in one country and the customer is located in another.

You will also find this document used in land development. This process is used to ensure that approved public infrastructure like streets, sidewalks, storm water ponds, and the like will be built. The parties involved in the deal are usually a beneficiary, an issuing bank and an advising bank. The beneficiary receives the money. The issuing bank is the bank of the applicant who is also a client and the advising bank is the bank of the beneficiary.

Nearly all of these letters of credit are irrevocable, meaning they cannot be undone. They cannot be amended. They cannot be canceled without prior agreement between the involved parties. Once a transaction with a letter of credit has been issued, its functions are similar to a Traveler’s check or giros.

If a beneficiary wants to receive payment, a commercial invoice or bill of lading must be presented in addition to documents ensuring that the shipment was insured against loss or damages.

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