TYPES OF CREDIT INSTRUMENTS AND ITS FEATURES

By students of
Department of Management Sciences,
University of Pune
(PUMBA)

Credit or loan is the act of giving money, property or other material goods
to another party in exchange for future repayment of the principal amount along
with interest or other finance charges. A loan may be for a specific, one-time
amount or can be available as open-ended credit up to a specified ceiling
amount.
Credit instruments are items that are utilized in the place of currency. Just
about all individuals and businesses make use of some type of credit instrument
on a daily basis. The ability to use a credit instrument instead of currency rests in
the fact that debtor and the recipient agree upon the use of the instrument and
there is a reasonable expectation that the alternate form of payment will be
honored.
The contractual amount of credit instruments represents the maximum
undiscounted potential credit risk if the counterparty does not perform according
to the terms of the contract, before possible recoveries under recourse and
collateral provisions. A large majority of these commitments expire without being
drawn upon. The credit instruments are issued by the lenders only to those
parties that are creditworthy. Credit risk for other credit instruments using the
same credit risk process that is applied to loans and other credit assets.
The terms of a standardized loan are formally presented (usually in writing) to
each party in the transaction before any money or property changes hands. If a
lender requires any collateral, this will be stipulated in the loan documents as
well. Most loans also have legal stipulations regarding the maximum amount of
interest that can be charged, as well as other covenants such as the length of
time before repayment is required.
Some credit instruments like credit derivatives are used for the risk-mitigation
purposes. These instruments help the lending firm to manage the credit risk
associated with borrower.

Principles of Lending

Lenders usually follow some principles before granting loan to the borrower. They
appraise the borrower on certain criteria which are described as follows.
Safety of the funds- This is most important criterion while granting a loan. The
funds should go in the safe hands.
Identification of borrowers (KYC) - Institutional lenders have to follow KYC
norms, which help them in identifying the borrowers.
Purpose- The purpose for which the loan is granted is important because on
this criterion interest rate applicable to the borrower and availability of certain
facilities is decided.
Liquidity- The borrower should always have liquid money with him so that the
chance of the borrower becoming NPA is less.
Security- The security offered for the loan plays important role, because in
future if the borrower could not repay, the security charged with the creditor
can be sold to recover the dues.
Profitability- Profitability of business to which the loan is granted is important
because non-profitable businesses generally turn into a NPA for the bank.
Risk Management- Managing the risk created due to granting of loan is
important. Because if the bank fails to manage various types of risks
associated with credit given, the recovery becomes impossible.
National Interest- Certain credit is given for the national interest and in these
cases profitability of the bank is not the primary issue. Priority sector lending
is the best example of the credit given in the national interest.

Types of Lending

Lending by the banks or the financial institutions can be divided into 3 major
types.

Fund-based lending
This is the most direct form of lending. It is granted as a loan or advance with
an actual outflow of cash to the borrower. It is supported by prime or
collateral securities.
Non fund based lending
There is no funds outlay for the Bank. It may crystallise into fund-based
advances, on account of the failure to fulfil the contract. Letters of credit and
bank guarantees, fall under this category.
Asset-based lending
 This is an emerging category of bank lending. The bank looks primarily to the
earning capacity of the asset being financed. Mostly, the banks do not have
any recourse to the borrower. Specialised lending practices such as
securitisation, or project finance fall under this category.

Common types of credit instruments

The vast majority of credit instruments involve a mixture of standard types. We

can broadly classify the credit instruments used by the lender as follows-
Credit instruments which are used for meeting working capital
requirements
Credit instruments used for meeting capital expenditure
Negotiable instruments like bill of exchange
Non-funded credit instruments like L/C and B.G.
Credit derivatives for risk mitigation
Other instruments

Working Capital

The credit for fulfilling working capital requirements is usually given by using
following modes of credit like cash credit, WCDL, overdraft like bills of exchange
and commercial paper. Bill of exchanges are discussed under negotiable
instruments.
The security offered for working capital finance is current assets like inventory,
book debts and receivables.

CASH CREDIT
It is the most popular method to finance working capital requirements of a
company in India. Under the cash credit facility, a borrower is allowed to
withdraw funds from the bank up to the sanctioned credit limit. He is not required
to borrow entire sanctioned credit once, rather, he can withdraw periodically to
the extent of his requirements and repay by depositing surplus funds in his cash
credit account. There is no commitment charge; therefore, interest is payable on
the amount actually utilised by the borrower. Cash credit limits are sanctioned
against the security of current assets such as inventory, receivables and debtors.
Though funds borrowed are repayable on demand, banks usually do not recall
such advances unless they are compelled by the adverse circumstances. Cash
credit is the most flexible arrangement from the borrowers point of view.

WORKING CAPITAL DEMAND LOAN

A borrower may sometimes require ad hoc or temporary accommodation in
excess of the sanctioned credit limit to meet unforeseen contingencies. Banks
provide such accommodation through a demand loan account or a separate non-
operable cash credit account. Such a loan is termed as working capital demand
loan. The borrower is required to pay a higher rate of interest above the normal
rate on such additional credit.

OVERDRAFT
It is similar to cash credit arrangement. Under the overdraft facility, the borrower
is allowed to withdraw funds in excess of the balance in his current account up to
a certain specified limit during a stipulated period. Though overdrawn amount is
repayable on demand, they generally continue for a long period by annual
renewals of the limit. It is very flexible arrangement from the borrowers point of
view sine he can withdraw and repay funds when ever he desires within the
overall stipulations. Interest is charged on daily balances, on the amount actually
withdrawn, subject to some minimum charges. The borrower operates this facility
through cheques.

COMMERCIAL PAPER
Commercial paper (CP) is an important money market instrument to raise short
term funds. CP is a form of unsecured promissory note issued by the firms to
raise short term funds. Only financially sound and highest rated companies are
able to issue commercial papers. The buyers of commercial paper includes
banks, insurance companies, mutual funds, trusts and firms with short surplus
funds to invest for a short period with minimum risk. Given this investment
objective demand for CPs of highly creditworthy companies will always be there.

In India, RBI regulates issue of CPs. Only those companies which have a net
worth of minimum Rs. 10 crores, MPBF of not less than Rs. 25 crores and which
are listed on stock exchange are allowed to issue CPs. The size of the issue
should be at least Rs. 25 lacs and size of the each CP should not be less than Rs.
5 lacs. A company can issue CPs amounting up to 75% of the MPBF. The maturity
of CPs in India usually runs between 91 to 180 days.

Interest rate on commercial paper is generally less than bank borrowing rate. A
firm does not pay interest on a CP but it sells it at a discounted value. The yield
calculated o this basis is referred to as interest yield which can be calculated as,

Interest yield = (face value) (sale price) * _____360_____

Sale price days of maturity

Interest on CP is tax deductible. In India, cost of a CP usually includes discount,

rating charges, stamp duty and issuing & paying agent (IPA) charges.

REVOLVER
A revolver (RV), or credit line or revolving line, is a credit agreement in which the
borrower has the right to choose when to obtain funds and when to repay funds
and how much to borrow, within limits set by the contract. These limits typically
stipulate a maximum borrowing amount (commitment), the date by which all
borrowed funds must be repaid, and the covenants that the borrower must
satisfy to qualify for receiving funds. In some cases, the agreement requires that
the borrower periodically clean up (pay down to a specified level) the facility
before re-borrowing.
The revolving line involves all of the complications of the term loan plus the
added feature of granting the borrower the right to choose when to borrow and in
what amounts. By providing funds virtually on demand, the revolver allows a
business to meet its working capital needs and to manage the liquidity risk
created by volatile cash flows. Different types of revolving lines account for the
major share of bank lending to businesses. By pooling revolvers across many
businesses, a bank eliminates through diversification most of the liquidity risk
that it inherits from customers.

Credit instruments used to meet capital expenditure

TERM LOAN
A loan from a bank for a specific amount that has a specified repayment schedule
and a floating interest rate is called as term loan.
A term loan (TL) is a credit contract in which the borrower receives funds from
the creditor(s) at contract closing or usually over a short period following closing
and, in return, agrees to make payments of interest, fees and principal based on
formulas and schedules specified in the agreement.
Often term loan is given to purchase fixed assets such as plant & machinery,
consumer products and house.
Term loans almost always mature between 1-10 years. But term loans like home
loans may be of maturity up to 20 years.
This kind of loan is preferred by many bankers because usually an asset is
created through this type of credit. Such asset provides security to the banker.
Term loans are always secured in nature. The assets created from the term loan,
are charged to the bank and are a primary security. In case of loans where no
asset is created like in case of personal loan; collateral is required.
Borrowers also prefer term loans for capital expenditure as they are less costly
than other sources of finance like equity and interest on the term loans is tax
deductible.
Term loans can be quite complicated, involving amortization of principal, differing
levels of seniority, posting of collateral, detailed covenant restrictions,
prepayment penalties and interest and fees that may vary with the borrowers
risk rating or financial performance.

LOAN SYNDICATION/ CONSORTIUM ADVANCE/ MULTIPLE BANKING

ARRANGEMENT
Loan syndication is the process of involving several different lenders in providing
various portions of a loan.
It is mainly used in extremely large loan situations; syndication allows any one
lender to provide a large loan while maintaining a more prudent and manageable
credit exposure because the lender isn't the only creditor.

A syndicated loan (or consortium advance or multiple banking arrangements) is a

large loan in which a group of banks provide funds for a borrower, usually several
but without joint liability. There is usually a lead bank or group of banks (the
"Arranger/s" or "Agent/s") that takes a percentage of the loan and syndicates or
sells the rest to other banks. In contrast, a bilateral loan, only involves one
borrower and one lender (often a bank or financial institution.) A syndicated loan
is a much larger and more complicated version of a participation loan. There are
typically more than two banks involved in syndication.

Syndicated loans can be underwritten or arranged on a best endeavors basis.

Where a loan is underwritten the Arrangers or Agents guarantee the terms and
conditions and costs of the loan before it is sold to other banks, essentially
removing the market risk for the Borrower.

BOND/ DEBENTURE
A corporate bond or a debenture is a credit instrument in which the issuer
obtains cash from the initial investors at origination and, in return, agrees to
make payments of interest and, at maturity, of principal to holders of the
securities. A bond or debenture is a long-term, fixed-income, financial security.
Debenture holders are creditors or lenders to the firm.
Bonds are less costly to the firm than equity because investors consider them a
less risky alternative and interest payments on bonds are tax deductible.
There is no ownership dilution as bond holders do not voting rights. Bond holders
receive interest at a predetermined rate. Also during high inflation period bond
issue benefits the borrowing firm.
From the creditors point of view it is a secure credit as bonds are usually secured
in nature i.e. they can take control over the assets of the company in case of
default. Also when the borrowing firm is liquidated bondholders have preference
over shareholders of the borrowing firm.
Some bonds include sinking fund or redemption provisions basically equivalent to
amortization of principal. Most allow prepayment after a period of call protection.
The bonds comparative simplicity makes it more readily marketable than other
credit agreements that, in contrast, often include clauses proscribing or limiting
assignments.
But issuing firm has the legal obligation of paying interest & principal on due
date. Also it increases financial leverage of the firm and disadvantageous to the
firms with fluctuating sales and earnings.

Modes of Charge

Most credit facilities are secured in nature i.e. some assets of the borrowing firm
are charged to the lender/ bank. So it will be important to know various types of
charges that can be laid on the assets by the lenders while granting the credit to
the borrower.
Lien
Lien is the right to retain securities/goods belonging to another, until a debt due
from the latter is paid.
Set off
It is in effect the combining of the accounts of the debtor and creditor, so as to
arrive at the net balance payable to one or the other.
Pledge
Pledge is bailment or delivery of goods as security for payment of a debt or
performance of a promise, as per section 172 of Indian Contract Act, 1872. Goods
are in the possession of the Bank. It is not a popular form of security.
 Hypothecation
When the possession of the property in the goods and other movables offered as
security remains with the borrower and only an equitable charge is created in
favour of the lender, the transaction is called a hypothecation. This is the most
popular method of creating security for banks.
Mortgage
Mortgage is the transfer of an interest in specific immovable property for the
purpose of securing the payment of money advanced by way of loan, an existing
or future debt or performance of an engagement, which may give rise to a
pecuniary liability.
As per sec 58 of transfer of property act 1882 the important types of mortgage
are:
Equitable mortgage
Registered mortgage or English mortgage
Assignment
Actionable claims are assigned by the borrowers to the bank.
A borrower can assign Book debts Life Insurance Policies Money due from Govt
departments or Semi-govt organisations.

Negotiable instruments

PROMISSORY NOTE
A promissory note, also referred to as a note payable in accounting, is a contract
where one party (the maker or issuer) makes an unconditional promise in writing
to pay a sum of money to the other (the payee), either at a fixed or determinable
future time or on demand of the payee, under specific terms. They differ from
IOUs (I owe unto) in that they contain a specific promise to pay, rather than
simply acknowledging that a debt exists. The terms of a note typically include the
principal amount, the interest rate if any, and the maturity date. Sometimes
there will be provisions concerning the payee's rights in the event of a default,
which may include foreclosure of the maker's assets.
Demand promissory notes are notes that do not carry a specific maturity date,
but are due on demand of the lender. Usually the lender will only give the
borrower a few days notice before the payment is due.
For loans between individuals, writing and signing a promissory note is often
considered a good idea for tax and recordkeeping reasons. In the United States, a
promissory note that meets certain conditions is a negotiable instrument
governed by Article 3 of the Uniform Commercial Code.
Negotiable promissory notes are used extensively in combination with mortgages
in the financing of real estate transactions. Other uses of promissory notes
include the capitalization of corporate finances through the issuance and transfer
of commercial paper.
At various times in history, promissory notes have acted as a form of privately
issued currency. In many jurisdictions today, bearer negotiable promissory notes
are illegal precisely because they can act as an alternative currency. All Scottish
and Northern Irish banknotes are effectively standardized demand promissory
notes.

BILL OF EXCHANGE
A bill of exchange or "Draft" is a written order by the drawer to the drawee to pay
money to the payee. The most common type of bill of exchange is the cheque,
which is defined as a bill of exchange drawn on a banker and payable on
demand.
Bill of exchange is most popular instrument of payment in financing the internal
and foreign trade in India. Funds lent under BP/BD are recoverable/ receivable
after short period of time. Banks provide credit facilities against such bills of
exchange in following ways, when banks,
Negotiate such bills payable on demand/ against acceptance
Purchases bills payable on demand
Discount bills drawn on DA basis
Grant advances against supply bills under collection

In the first 3 cases Bank becomes holder in due course for full value of bills and
in the fourth case it is holder in due course for value up to the advances granted
against such bills.
Bills of exchange are written orders by one person to his bank to pay the bearer a
specific sum on a specific date sometime in the future.
When bills are purchased, such bills are payable on demand. When bills are
discounted, such bills are payable after some usance period.
Banks collect commission and interest on the day of purchase/discount, the
advance sanctioned results into higher yield. The effective rate of interest is
more than what bank earns under Cash Credit or Term Loan.

Types of bills:
Bills to be purchased/ discounted could be documentary or clean and demand or
usance. When the instrument (bill) is accompanied by document of title of goods
(such as bill of lading, railway receipt, motor receipt etc.) it is documentary bill
and when no such documents of title to the goods accompany the bill, it is a
clean bill. However when documents of title to goods are delivered against
acceptance of a bill, the documentary usance bill gets converted into a clean bill.

An example of bill of exchange

Transaction Process
CHEQUE
A cheque is an unconditional order, drawn on a specified banker and is payable
on demand.
Cheque is one of the earliest forms of a credit instrument. It is utilized by
consumers as a legitimate means of paying for goods and services received; the
value of the cheque is underwritten by funds that are placed in a bank account.
Upon the presentation by the recipient of the credit instrument, the bank deducts
the specified amount as recorded on the cheque by the debtor. While the cheque
is no longer the main credit instrument employed in many financial transactions,
it remains in use by many businesses and individuals.

General crossing - Sec 123 of Negotiable Instrument Act.

Where a cheque bears across its face an addition of the words and co or any
abbreviation thereof, between two parallel transverse lines simply, either with or
without the words not negotiable, that addition shall be deemed a crossing and
the cheque shall be deemed to be crossed generally.

Special crossing - Section 124 of Negotiable Instrument Act.

Where a cheque bears across its face an addition of the name of a banker, either
with or without the words not negotiable, that addition shall be deemed a
crossing and the cheque shall be deemed to be crossed specially and to be
crossed to that banker.

Not negotiable crossing - Section 130 of Negotiable Instrument Act.

A person taking a cheque crossed generally or specially, bearing in either case
the words not negotiable shall not have and shall not be capable of giving a
better title to the cheque than that which the person from whom he took it had.

Payment of cheques
Section 126 of Negotiable Instrument Act
Where a cheque is crossed generally, the banker on whom it is drawn shall not
pay it otherwise than to a banker and where a cheque is crossed specially, the
banker on whom it is drawn shall not pay it otherwise than to the banker to
whom it is crossed or his agent for collection.

Different types of Payment of Cheques

Following are the various types of payment of cheques.
Ante dated
Post dated
Stale cheques
Amount in words and figures differs (sec 18 of N I Act) )
Authentication of alterations
Forgery of drawers signature
Payment during banking hours
Protection to paying banker - 85(1) order cheques, 85(2) bearer cheques

Refusal of payment of cheques

A banker can refuse to pay to the drawee against the cheque in following
conditions-
Payment countermanded by the drawer
Death of the drawer
Insolvency of the drawer
 Insanity of the drawer
Garnishee order
Breach of trust trust accounts
Defective title of the property
Mutilated cheques

Non-funded credit instruments

LETTER OF CREDIT
In a financial letter of credit (LC), the creditor guarantees the repayment of
counterpartys obligation and, in return, receives a one-time or periodic fee.
Thus, a bank could issue a financial LC in support of a customer obtaining short-
term cash from a money market fund that offers an attractive rate. In a financial
LC, the bank essentially provides credit insurance. The instruments contingent
pay-offs mirror those of a credit default swap.
A Letter of Credit (LC) is a letter from a bank guaranteeing that a buyer's
payment to a seller will be received on time and for the correct amount. In the
event that the buyer is unable to make payment on the purchase, the bank is
required to cover the full or remaining amount of the purchase. A letter of credit
is often abbreviated as LOC or LC, and is also referred to as a documentary
credit.
The parties to a letter of credit are usually an applicant who wants to send
money, a beneficiary who will receive the money, the issuing bank and the
advising bank.
Letters of credit are often used for international transactions to ensure that
payment will be received. They have become an important aspect of
international trade, due to differing laws in each country and the difficulty of
knowing each party personally.
The bank also acts on behalf of the buyer, or holder of the letter of credit, by
ensuring that the supplier will not be paid until the bank receives confirmation
that the goods have been shipped.
A letter of credit is often confused with a bank guarantee, which is similar in
many ways but not the same thing. The main difference is the bank's position
relative to the buyer and seller of a good or service in the event of the buyer's
default of payment. With a letter of credit, a seller may request that a buyer
provide them with a letter obtained from a bank which substitutes the bank's
credit for their client's.
In the event of the borrower defaulting, the seller can go to the buyer's bank for
the payment. Instead of the risk that the buyer will not pay, the seller only faces
the risk that the bank will be unable to pay, which is unlikely. This means that if
the applicant obtaining the letter of credit fails to perform his or her obligations,
the bank must pay.
The letter of credit can also be the source of payment for a transaction, meaning
that an exporter will get paid by redeeming the letter of credit. A letter of credit
is less risky for the merchant, but even riskier for a bank.
BANK GUARANTEE
A bank guarantee is defined under Section 126 of the Indian Contracts Act 1872
as follows: A contract to perform the promise or discharge the liability of a third
person in case of his default. The person who gives the guarantee is called the
surety; the person in respect of whose default the guarantee is given is called the
principal debtor and the person to whom the guarantee is given is called the
creditor. A guarantee may be either oral or written.
The liability of a guarantor comes into existence upon the failure of a debtor. If
the guarantor extinguishes the liability of a debtor then the guarantor will acquire
all the rights of the creditor, which is known as Right of Subrogation. Banks
extend guarantees on behalf of their clients. These guarantees are classified as
financial guarantees and performance guarantees.

Financial Guarantees
The bank guarantees its customers credit-worthiness and his or her capacity to
take up financial risks. Financial guarantees are typically issued for the following
purposes:
In lieu of Earnest Money/Tender deposit/Retention money.
Issued to Government departments for releasing disputed claim money like
excise duty/customs duty etc.
For example, if a contractor wants to bid for a tender, he or she needs to deposit
a specified sum of money known as Earnest Money Deposit (EMD). This amount
will be refunded to him or her if the work is not allotted to him or her. This
involves blocking of funds for a specified period which varies depending on the
nature of contract. This can be avoided by submitting a bank guarantee in the
place of EMD. The bank undertakes to pay the money if the contractor is awarded
the work but fails to pay the EMD.

Performance Guarantees
The bank guarantees obligations that relate to the technical, managerial,
administrative experience and capacity of the customer. The liabilities under the
performance guarantees are reduced to monetary terms. Performance
guarantees typically cover the following areas:
For performance of machinery/goods supplied deposit/Retention money
For satisfactory performance of Turnkey projects for a specific period for
releasing disputed claim money like excise duty/customs duty, etc.
In the above example, if the contract is awarded to the contractor, then the
agency awarding the contract seeks an assurance that the contract completed is
up to their satisfaction. Hence, they insist for a bank guarantee where a bank
undertakes to compensate the agency for any loss suffered consequent to poor
performance/non-performance.

Deferred Payment Guarantee

This guarantee is issued for guaranteeing payment of specified amount over a
period of time. The required margin, security and commission payable are
determined on the basis of type of guarantee and creditworthiness of the
customer. In cases of equipment financing by banks, the manufacturer by him or
her or through a financing tie-up offers credit to the buyers at very attractive
terms to generate additional demand for his or her products. However, the
manufacturer may not be willing to assume the risk of default by the buyer and
consequently demand a guarantee from the buyers bankers that the terms of
such financing would be met.
Notwithstanding the classification of guarantees into financial and performance,
the liability of a bank will always be determined in financial terms and banks are
obliged to pay the amount demanded by the beneficiary subject to the limit up to
which the bank agreed to make itself liable under a guarantee.
While these guarantees do serve as non-fund based services serving the purpose
of working capital management, there are also instances where banks may issue
guarantees for financing capital equipment.
The Deferred Payment Guarantee (DPG) is a bank facility where the bank does
not directly extend a loan to a unit for acquiring equipment. Instead, it extends a
guarantee to the equipment manufacturer on behalf of its client that the finance
extended by the manufacturer (by himself or through its preferred financier)
would be repaid as per the terms agreed upon. The advantage to the buyer here
is that he or she benefits to the extent of savings in interest charges accruing on
account of opting for equipment financing, minus the guarantee charges paid to
the bank.
In the normal course where the guarantee does not transfer onto the banker, the
banker stands to earn fee-based income.
Normally, such financing is done by extending a term loan. Suppose a supplier of
capital equipment is willing to extend a long-term credit to the buyer. This will
involve the supplier taking a credit risk and also blocking funds over the term of
the credit. If the supplier is not willing to take the credit risk then he or she may
insist a bank guaranteeing the credit extended to the buyer. In such
circumstances, the bank can extend a deferred payment guarantee. The bank,
under the deferred payment guarantee, undertakes to pay the installments if the
buyer fails to pay the same.
While these guarantees were in vogue earlier they have slowly disappeared from
the scene with the entry of Bill Rediscounting Scheme introduced by IDBI/SIDBI.
Under the scheme, the supplier draws different Bills of Exchange for each of the
installment and have the same accepted by the buyer and the buyers banker as
well. He or she will then have these bills discounted with his or her banker, which
will eliminate the need for him or her to block the funds. The sellers bank will in
turn rediscount these bills with IDBI/SIDBI. Thus, the sale of capital equipment is
effectively financed by IDBI/SIDBI.
However, the credit risk is taken by the buyers banker since all others have a
banker to fall back on. When the sellers bank rediscounts these bills they appear
as contingent items in the banks balance sheet even though credit has been
initially extended to the seller. Hence, these items are added to the Net Bank
Credit to obtain Gross Bank Credit.

Shipping and Railway Guarantee

A bank is requested to issue shipping and railway guarantee when the shipping
documents are not received but the ship carrying the goods has arrived and the
shipping company agrees to deliver the goods against the production of a bank
guarantee. As this guarantee does not specify the amount of guarantee it is
issued only on behalf of very respectable customers and usually against 100%
margin. Normally, these guarantees are issued only when the bill is routed
through the bank. Margin is fixed after determining the value covered by the bill.
Full margin should be stipulated even when the bill is drawn against a letter of
credit issued by the bank. However, where the borrower enjoys Trust Receipt
Limit, the guarantee can be issued against the execution of TR without insisting
on 100% margin.

The features of Shipping and railway guarantee are that they-

Enable immediate possession of the goods before payment.
Avoid unnecessary delays to the day-to-day running of your business.
Eliminate expensive demurrage/storage charges.
Defer payment until your suppliers documents have been presented.
Banks issue a shipping guarantee to the shipping company, undertaking to
forward the title documents (e.g. Bills of Lading) when they are received. This
allows the trader to take immediate control of the goods without the transport
documents. Shipping guarantees are usually applicable under import
Documentary Credit transactions, allowing prompt clearance of goods ahead of
documents arrival. However, by taking the goods, protection against discrepant
documents will be lost. Under normal circumstances, 100% cash margin against
the value of the goods will be required if the trader does not have Trust Receipt
facility. Shipping guarantees are only of value if they are issued immediately.

In the case of usance bill with trust receipt facility, the usance should start to run
from the date of issue of a guarantee and not from the date of acceptance of the
bill. Before issuing the shipping guarantee the bank must obtain an undertaking
to the effect that the borrower must honor the bill irrespective of discrepancy, if
any, with the terms of the LC.

Credit Derivatives to mitigate the credit risk

Credit derivatives are effective tools to hedge credit risk. Credit risk can be
defined as default risk arising on account of borrowers inability to pay back
loans. Any lending institution carries out credit analysis of a borrower and
prepares his risk profile. But, as no risk can be completely mitigated, there is
always a possibility of borrower default.

Due to large amount of defaults that took place in the US housing loan markets in
early 90s, banks found out innovative ways to hedge risks, which led to
expansion of derivative markets, where lenders could hedge against the risks. In
2000, the notional principal outstanding in these markets was $800 billion.
Currently, this market stands somewhere around $600 trillion. This shows the
stupendous turnover taking place in this market.
Some of the commonly used credit derivatives are discussed as follows.

CREDIT DEFAULT SWAPS (CDS)

This is the most popular credit derivative. The popularity of this derivative can be
seen from the fact that AIG, worlds largest insurer had worth $60 trillion
outstanding positions in CDS at the time of its taking over by Federal Reserves.
In a credit-default swap (DS) the buyer pays a one-time or periodic fee to the
seller of protection for the right, in the case of default by a particular borrower, to
receive cash compensation or to sell a credit instrument issued by the borrower
at a specified price (near par). In contracts with extremely low-risk
counterparties, this instrument offers basically the same state-contingent cash
flows as a financial LC. Otherwise, the instrument involves counterparty risk as
well as the risk of the underlying instrument. As with a financial LC and insurance
contracts in general, the protection buyer in a DS typically has the right of
canceling (prepaying) the agreement.
This contract provides insurance against default by a particular company. The
company is known as reference entity, and the default by the company is known
as credit event. The buyer of the insurance obtains the rights to sell bonds issued
by the defaulting company at their face value when a credit event occurs and the
seller agrees to buy these bonds at face value when credit event occurs. The
total face value of a bond is called the notional principle. The buyer of CDS
makes periodic payments to the seller of CDS until default occurs. Once the
default occurs, the seller buys the bonds issued by the defaulting company for its
face value. The settlement in the event of a default involves either physical
delivery of the bonds or cash payments.

TOTAL RETURN SWAPS (TRS)

In a total-return swap (TRS) the protection buyer exchanges the total returns on a
specified underlying debt instrument for a set of stable cash flows. The protection
seller receives cash flows that match the interest and principal payments plus
the gains (minus the losses) of the underlying instrument. As in the CDS, the TRS
can involve counterparty risk in addition to the risk of the underlying instrument.
Also, as in the CDS, the TRS usually allows the protection buyer to cancel the
agreement.
A total return swap is a type of credit derivative. It is an agreement to exchange
total return on a bond (or any asset) for LIBOR plus a spread. The total return
includes coupons, interest, and the gain or loss on the asset over the life of the
swap.

At the end of the life of the swap there is a payment reflecting the change in the
value of the bond, and subsequent payments are made.
This swap can be seen from 2 angles. For the payer of the bond, he gets a hedge
against the uncertainties in bond value for paying a premium above LIBOR. For
the receiver of the bond, this transaction is equivalent to invest in the reference
bond by borrowing at the rate equal to LIBOR + premium.

Collateralized Debt Obligations (CDOs)

CDO is a way of creating securities with widely different risk characteristics from
a portfolio of debt instruments.
An example is shown below. In this, 4 types of securities are created from a
portfolio of bonds. The first basket has 5% of total bond principle and absorbs all
credit losses from the portfolio during the life of the CDO until they have reached
5% of total bond principle. The second basket has 10% of total principal and
absorbs all loses in excess of 5% up to maximum 15%. The third basket has
principal up to 10% and absorbs all the losses in excess of 15% up to maximum
25%. The 4rth basket has 75% of the principal amount and absorbs the residual
losses. The yields specified are the returns the investors are going to get in those
specific baskets. For e.g. the investor in the first basket is going to get 35% on his
initial investment. Once the value of total portfolio descends by 1%, his
investment goes down by 20%, the next time he is going to get 35% on 80% of
his investment.

1st 5%loss
Bond 1 Yield 35%
Bond 2
Bond 3
. 2nd 10%
Trust loss, yield
.
. 15%
Bond n
3rd 10%loss
Yield 7.5%
Average
Yield
8% Residual
loss, yield
6%

Other Instruments

CREDIT CARD
The credit card is an example of a common credit instrument. Using a credit card
to pay for a purchase creates a contract between the buyer and the seller.
Essentially, the seller is extending credit to the buyer with the assumption that
the company issuing the card will cover the amount of the purchase. In turn, the
issuer of the credit card is anticipating that the cardholder will eventually pay off
the amount of the debt along with applicable interest and finance charges.
With this arrangement, credit card holders receive credit from the lenders with
the understanding that the same will be repaid in full at a future point in time.
This type of obligation may carry a specific date for repayment and if the credit
card holder is liable for a penalty. There are two main advantages to the use of a
credit card. First, the consumer does not have to carry a great deal of currency in
order to make purchases. Second, a credit card can usually be replaced with
relative ease when damage, loss, or theft of the instrument takes place. This is in
contrast to cash, which usually cannot be replaced when damaged, stolen, or
lost.

MULTI-OPTION CREDIT FACILITY (MOF)

In a multi-option credit facility (MOF), the borrower has access to a range of
instrument types within a single facility or contract. In this case, the creditor
commits to provide credit up to a maximum amount, which can amortize over
time, to be drawn on in various ways largely at the borrowers discretion. In a
more general case, the borrower can receive a term loan and then, as needed,
obtain additional credit up to the remaining commitment amount. This additional
credit can take the form of additional funded balances (revolvers), letters of
credit, bankers acceptances, or some combination of these types. Of course, an
MOF can offer less than the full menu of instrument types.

BANKERS ACCEPTANCE (BA)

A bankers acceptance (BA) is another type of payment guarantee. A short-term
credit investment created by a non-financial firm and guaranteed by a bank. A
banker's acceptance or BA is a time draft drawn on and accepted by a bank. In a
BA, the bank certifies that it will stand behind time drafts (usually post-dated
cheques) issued by a customer. The customer may then sell drafts endorsed as
accepted by the bank at a discount to a funding source that does not want to
bear the issuers credit risk.
Before acceptance, the draft is not an obligation of the bank; it is merely an order
by the drawer to the bank to pay a specified sum of money on a specified date to
a named person or to the bearer of the draft. Upon acceptance, which occurs
when an authorized bank accepts and signs it, the draft becomes a primary and
unconditional liability of the bank.
If the bank is well known and enjoys a good reputation, the accepted draft may
be readily sold in an active market. Acceptances are traded at a discount from
face value on the secondary market. Banker's acceptances are very similar to T-
bills and are often used in money market funds.