Describe the process involved in financing imports and exports using a letter of credit. Why has this system developed? What is the advantage of using this system?
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A Letter of credit can be referred to as a bank's promise to undertake or take the responsibility of payments of the merchandise on behalf of the importer.
The process involved in financing imports and exports using a letter of credit are as follows:
1. Sales contract and formal agreements
The importer and the exporter agrees on a transaction and makes a draft of a sales agreement.
2. Application and agreement
In this step, the exporter applies for the issuance of a letter of credit from its local bank.
3. Issuance of the letter of credit
The bank issues a letter of credit and creates a sales contract based on the assessment of the importers credit worthiness.
The bank therefor advices the exporter whether it has honored the offer to pay for the transactions or not.
Advantages of letter of credit
- It reduces the risk of payments associated with the movement of goods
- reduces the risk of non completion of business since the bank agrees to pay against the documents rather than the actual merchandise
The documents involved in this type of business are:
- A draft
- commercial invoice
-Bill of lading
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