What is the Letter of Guarantee?

Examples of Letter of Guarantee

Let’s discuss examples of letters of guarantee for better understanding.

Example #1 – Overseas Trade

Say there is a supplier for expensive antique products in Brazil. A customer from London wants to buy products from the supplier. The customer will not be willing to make the payment before the delivery of the product as he is thinking, what if the supplier doesn’t supply after receiving the payment. The supplier is also thinking the same way if the customer doesn’t pay after receiving the product.

So what the customer can do is go to a bank and apply for a “letter of guarantee.” In this letter, it will be written that if the customer doesn’t pay the money, the bank guarantees that the bank will pay. Once the customer has the letter, he can send it to the supplier, and in return, the supplier will send the goods to the customer as he will not have to worry about the default in payment. Bank will charge a fee for this service from the customer.

Example #2 – New Supplier in Business

When a supplier knows its customer very well, then he is fine in supplying goods to the customer without worrying. In the case of new suppliers, the supplier may want a guarantee that he will be paid once the customer receives the product. So, in this case, the customer will have to reach a bank and apply for a “letter of guarantee.”

Example #3 – Companies at Start-Up Stage

Companies during the start-up stage don’t have goodwillGoodwillIn accounting, goodwill is an intangible asset that is generated when one company purchases another company for a price that is greater than the sum of the company’s net identifiable assets at the time of acquisition. It is determined by subtracting the fair value of the company’s net identifiable assets from the total purchase price.read more in the market. For them, getting products from the supplier is difficult without full payments. So they rely on a letter of guarantee to get products delivered to them.

Example #4 – Call Writer

In incall writing, if the share price increases, then an unlimited loss is probable. So in call writing the broker asks forCash and Cash Equivalents are assets that are short-term and highly liquid investments that can be readily converted into cash and have a low risk of price fluctuation.  Cash and paper money, US Treasury bills, undeposited receipts, and Money Market funds are its examples. They are normally found as a line item on the top of the balance sheet asset. read more cash or equivalent securitiesCash Or Equivalent SecuritiesCash and Cash Equivalents are assets that are short-term and highly liquid investments that can be readily converted into cash and have a low risk of price fluctuation.  Cash and paper money, US Treasury bills, undeposited receipts, and Money Market funds are its examples. They are normally found as a line item on the top of the balance sheet asset. read more as guarantees. Many institutional investors maintain an investment account with custodian banks. So say that an institutional investorInstitutional InvestorInstitutional investors are entities that pool money from a variety of investors and individuals to create a large sum that is then handed to investment managers who invest it in a variety of assets, shares, and securities. Banks, NBFCs, mutual funds, pension funds, and hedge funds are all examples.read more holds 1000 shares of ABC company and writes a call option on the shares.

So if the share price starts to rise, he will lose money on the contract he has written. So for this, the broker needs the guarantee that he will pay when he incurs a loss. So the institutional investor can go to the custodian bank and ask for a letter of guarantee. As the custodian bank is holding the shares for the company, they can give a letter that if the share price rises, they can pay on the institutional investor’s behalf.

Example #5 – Bond Issuance

It is common in the case of bond issuance. When a company issues bonds with a “letter of guarantee” by the bank, it is treated as a secured bondA Secured BondA secured bond is when the bond’s issuer provides a specific asset as collateral and offers a reduced interest rate compared to unsecured bonds. In case of default, the issuer is obligated to transfer the title of the collateralized asset to the bondholder.read more and trades at a premium. Here the bank may guarantee to pay the interest or principal or both in case of default.

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How to Get a “Letter of Guarantee”?

Advantages

  • It helps new businesses grow as banks help them get goods from suppliers.It helps in overseas trade and increases export and import.It protects the buyer of bonds from defaults.

Disadvantages

Some of the disadvantages are as follows.

  • Write an application to the bank. To get a letter of guarantee, one will have to write an application to the bank. Bank determines whether the applicant qualifies or not. When a bank receives an application, it will have to determine whether the applicant qualifies for the same. Bank goes through transactions deeply. The bank does this by going through the transaction deeply; it will also check the previous transactions and every relevant material required to make the judgment. Fee Bank charges fees to give this letter.

To get a letter of guarantee, one will have to write an application to the bank.

When a bank receives an application, it will have to determine whether the applicant qualifies for the same.

The bank does this by going through the transaction deeply; it will also check the previous transactions and every relevant material required to make the judgment.

Bank charges fees to give this letter.

  • It doesn’t guarantee 100% protection. If the claim amount is big, then the party who has acted as a guarantor may not be able to cover up the claim completely.As the bank acts as a guarantor, it enablesBond Issuers are the entities that raise and borrow money from the people who purchase bonds (Bondholders), with the promise of paying periodic interest and repaying the principal amount when the bond matures.read more bond issuersBond IssuersBond Issuers are the entities that raise and borrow money from the people who purchase bonds (Bondholders), with the promise of paying periodic interest and repaying the principal amount when the bond matures.read more to issue more bonds than required, and if they default, the bank will make the payment. So the default rate increases.

Conclusion

It is an important part of the economy now. It helps in the smooth running of the business across borders. A letter of guarantee has made the bond market more secure, and investors are willing to invest in risky bonds withThe term “Bank Guarantee,” as the name suggests, is the guarantee or assurance given by a financial institution to an external party if the borrower cannot repay the debt or meet its financial liability. In such an event, the bank will repay such an amount to the party that has been issued with the guarantee.read more bank guaranteesBank GuaranteesThe term “Bank Guarantee,” as the name suggests, is the guarantee or assurance given by a financial institution to an external party if the borrower cannot repay the debt or meet its financial liability. In such an event, the bank will repay such an amount to the party that has been issued with the guarantee.read more.

This has been a guide to a letter of guarantee and its meaning. Here we discuss examples of letters of guarantee along with advantages and disadvantages. You can learn more about finance from the following articles –

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