Types of Instruments of Credit:
In addition to bills of exchange, there are several other types of financial instruments that serve as instruments of credit and play a significant role in trade and finance. These instruments provide various forms of credit arrangements, payment guarantees, and financing options for businesses and individuals. Here’s a detailed overview of some common types of instruments of credit:
1. Promissory Note:
A promissory note is a written promise made by one party (the maker or issuer) to pay a specific sum of money to another party (the payee or holder) at a designated future date or upon demand. Unlike bills of exchange, promissory notes involve only two parties, the issuer and the payee. Promissory notes are often used in loan agreements and other credit transactions.
Key Elements of a Promissory Note:
- Date of issuance.
- Amount of the note.
- Due date or terms of repayment.
- Interest rate (if applicable).
- Signatures of the issuer and payee.
2. Banker’s Acceptance:
A banker’s acceptance is a time draft drawn on and accepted by a bank, which provides a guarantee of payment. It is typically used in international trade to facilitate financing and payment arrangements. Banker’s acceptances are often sold in the secondary market before maturity, providing liquidity to the holder.
3. Letter of Credit:
A letter of credit (LC) is a financial instrument issued by a bank on behalf of a buyer (applicant) to guarantee payment to a seller (beneficiary) for goods or services. The bank undertakes to make payment upon the presentation of specified documents, ensuring that the seller receives payment once the terms of the LC are met. Letters of credit are widely used in international trade.
4. Trade Credit:
Trade credit is a common form of credit arrangement in which a seller extends credit terms to a buyer, allowing the buyer to delay payment for goods or services received. It is often granted based on the buyer’s creditworthiness and relationship with the seller. Trade credit is a flexible and convenient form of short-term financing.
5. Commercial Paper:
Commercial paper is a short-term, unsecured promissory note issued by corporations to raise funds for working capital needs. It is typically sold to institutional investors in the money market. Commercial paper offers a cost-effective way for corporations to obtain short-term financing.
6. Factoring:
Factoring is a financing arrangement in which a business (factor) purchases accounts receivable from another business (seller) at a discount. The factor provides immediate cash to the seller and takes on the responsibility of collecting the receivables from the buyers. Factoring helps businesses improve cash flow and manage credit risk.
7. Forfaiting:
Forfaiting is a form of trade financing in which a financial institution (forfaiter) purchases the right to receive future cash flows from a buyer’s promissory note or other payment obligation. The forfaiter assumes the credit risk and provides immediate funds to the seller.
8. Installment Credit:
Installment credit involves making fixed payments over a specified period to repay a loan for a large purchase, such as a car or appliance. The loan agreement outlines the repayment schedule, interest rate, and terms.
9. Revolving Credit:
Revolving credit provides a pre-approved credit limit that a borrower can access as needed. It is commonly used for credit cards and lines of credit. Borrowers can use and repay the credit repeatedly, making it a flexible form of financing.
Each type of instrument of credit serves specific purposes and provides unique benefits to businesses and individuals. They play a crucial role in facilitating trade, managing cash flow, and providing access to financing in various economic activities.