Bankers’ Acceptance

Bankers’ Acceptance

A bankers’ acceptance is a bank’s commitment to pay someone else’s promise to pay a specified amount at a specified date. With a bankers’ acceptance, the bank is committing itself to making the specified pay- ment at the maturity of the draft if the issuer of the draft does not pay.

A draft is a written order by one party that orders a second party to make payments to a third party. A check is a draft: written by a deposi- tor, ordering the second party (the financial institution) to pay a third party (an institution or individual). A sight draft orders the payment immediately (on “sight”) upon presentation. A time draft orders pay- ment after a specified period of time. Bankers’ acceptances are typically used in international trade, though they may be used domestically as well. They generally have maturities less than 270 days, hence, they are time drafts.

Although there are a variety of ways a bankers’ acceptance can be arranged, the basic idea behind all of them is that a letter of credit is trans- formed into a security that can be bought and sold in the open market.

Suppose a bank issues a letter of credit to assist an importer in the payment of goods. The exporter wants cash now, not the letter of credit. So the exporter takes the letter of credit to her bank and receives her funds now. But she receives less than the face value of the letter of credit. By cashing it in, rather than waiting for maturity, she receives less money. The exporter’s bank may not want to hold onto the letter of credit until maturity, so the exporter’s bank exchanges it for funds with the importer’s bank. First the letter of credit is exchanged for a time draft—a promise of the importer’s bank to pay. Then the draft is exchanged into funds with the importer’s bank. The importer’s bank is now holding a time draft that it issued. The bank can either hold it as an investment, or sell it to an investor. This process is diagrammed in Exhibit 21.8.

EXHIBIT 21.8 How Bankers’ Acceptances Provide Financing for Export-Import

Transactions Round 1: Exporter Sells Goods to Importer

MANAGING WORKING CAPITAL

EXHIBIT 21.8

(Continued) Round 2: Exporter Presents Letter of Credit to its Bank

Round 3: Exporter’s Bank Sells Time Draft to Importer’s Bank

Round 4: Importer’s Bank Sells Acceptance to an Investor

Round 5: The Banker’s Acceptance Matures and the Importer’s Bank Pays Cash to the Investor

Management of Short-Term Financing

The cost of a bankers’ acceptance comprises: a commitment fee or commission for the commitment, and the interest rate on the loan if the bank makes the payment for the issuer. The interest is usually stated as discount interest—the difference between the price paid and face value. The amount specified in the letter of credit is for the price of the goods plus interest; the face value of the acceptance is some amount larger than the price of the goods, with the difference being the interest on the loan. This is similar to trade credit: The exporter, by cashing in the let- ter of credit gets the cash price of the goods, but if he waited, he would get this cash price plus interest.

When the bankers’ acceptance is sold to investors, it is sold at a dis- count from the face value, so when it matures, the purchaser of the goods (the importer in our example) pays face value. If the purchaser cannot pay the face value, the bank will because it has accepted the responsibility for payment.

A bankers’ acceptance is similar to commercial paper. They both can be traded among investors, both have maturities less than 270 days, and both generally have discount interest. But they differ in two ways:

1. The way that they are created.

2. Their risk. Commercial paper is backed by the issuer, which may have

a back-up line of credit; bankers acceptance is backed by the issuer, yet the bank stands ready to pay the face value. The lower risk on the bankers’ acceptances results in slightly lower yields than the yields on the commercial paper.