Bills of exchange primarily act as promissory notes in international trade; the seller, or exporter, in the transaction addresses the bill of exchange to the buyer, or importer. A third entity, typically a bank, is party to many bills of exchange to help guarantee payment or receipt of funds. This helps reduce any counterparty risk inherent to the transaction.
Think of a simple bill of exchange like a bank check. The check specifies who receives the funds, how much is paid and the date on which the payment takes place. Many different kinds of bills of exchange can be drafted depending on the demands of the parties involved. Bills are also negotiable instruments that can be bought and sold in secondary market transactions.
Bill of Exchange in International Trade
International trade presents unique risks that are not often present in domestic transactions. There are several reasons for this, such as separate legal jurisdictions and lengthy transportation routes. Most of these trades require currency exchanges, making long-term trade arrangements sensitive to exchange-rate fluctuations.
Traditionally, the exporter or the exporter's bank draws up the bill of exchange and submits the document through the importer's bank; the importer's bank offers a contingent guarantee on the transaction. If the importer dishonors the bill of exchange and fails to make payment, the importer's bank makes the payment and then pursues its customer to be made whole.
Trading Bills of Exchange
As marketable instruments, bills of exchange can be sold to outside parties. Normally, the bill is discounted or sold for an amount that is less than the par value of the contract. Like a bond, the discount tends to be greatest when the maturity date of the contract is farthest away. When tendered by the debtor, the new owner of the bill of exchange receives future payments. The final amount paid through the bill of exchange is unchanged.