What is a letter of guarantee?
A letter of guarantee is one kind of contract that a bank will issue on behalf of a client who has signed a contract to buy products from a supplier. The letter of guarantee assures the provider that they will get payment regardless of the bank’s customer default. Like with a loan, the consumer must apply for a guarantee letter. For an annual charge, the bank will provide the customer with the letter if they feel comfortable taking on the risk.
On behalf of a call writer, a bank may also issue a letter of guarantee stating that the writer owns the underlying asset and that the bank will deliver the underlying assets if the call is exercised. When the underlying asset of a call option is not kept in the call writer’s brokerage account, the letter of assurance is frequently used.
Comprehending Guarantee Letters
When one party to a transaction is unsure that the other side can fulfill their financial obligation, letters of guarantee are frequently employed. This is particularly typical when expensive machinery or other property is purchased. However, a letter of assurance might not pay off the entire obligation. In a bond offering, for instance, a letter of guarantee might guarantee repayment of principal or interest, but not both.
The bank and their client will haggle over the amount covered. For this service, banks charge a yearly fee, usually a portion of the amount the bank would repay if a client defaults.
A Call Writer’s Guarantee Letter
A broker will frequently accept a letter of guarantee for call writers with short options instead of keeping cash or securities because many institutional clients keep their investment accounts at custodian banks rather than broker-dealers. The guarantee letter needs to be in a format that the exchange and possibly the Options Clearing Corporation have approved. If the account of the call writer is assigned, the issuing bank consents to provide the broker with the underlying securities.
An illustration of a guarantee letter
Let’s say that Company XYZ is spending $1 million on a sizable piece of specially made equipment for their shop. Since the equipment provider will need to fabricate it, it might not be available for several months. The supplier does not want to spend time and money developing this piece of equipment without an assurance that the buyer will purchase it and has the funds to do so, even when the buyer does not want to pay right now. The buyer can obtain a letter of assurance by visiting their bank. Given that the bank supports the buyer, this should help alleviate that supplier.
Let’s say a call writer is short ten contracts of imaginary stock. That is the same as one thousand shares. Those short-call bets will be losing money if the stock price rises, and since there is no limit to how much a stock may climb, the loss might be endless. However, the risk is reduced if the call writer owns 1,000 shares of the stock. This call is protected.
The broker might have thought the uncovered short call was too hazardous; thus, to short the contracts in the first place, the writer might have needed to provide a letter of guarantee proving they owned the stock (in another account; otherwise, the broker would not have needed the letter).
Conclusion
- A letter of guarantee is an agreement a bank makes on behalf of a customer who has agreed to buy things from a seller.
- With a letter of guarantee, the seller knows that they will get paid even if the bank customer doesn’t pay.
- A bank can give a call writer a letter of guarantee that says the writer owns the underlying asset and that the bank will send the underlying securities if the call is taken.
- People often use letters of guarantee when they aren’t sure the other person will be able to pay their debts. This is especially common when buying expensive tools or other property.
- You can use letters of guarantee for many business purposes, such as contracts and building, getting money from a bank, or making statements during the export and import processes.
