A German bank issues a three-month letter of credit on behalf of its German customer who is planning to import $100,000 worth of goods from the United States. The bank charges an up-front fee of 100 basis points.
a. What up-front fee does the bank earn? How is this fee recorded on the bank’s income statement?
b. If the U.S. exporter decides to discount this letter of credit after it has been accepted by the German bank, how much will the exporter receive, assuming that the interest rate currently is 5 percent and that 90 days remain before maturity? (Hint: To discount a security, use the time value of money formula, PV = FV [(1 – (interest rate x (days to maturity/365))].)
c. What risk does the German bank incur by issuing this letter of credit?