A banker’s acceptance refers to a financial instrument that represents a promised future payment from a bank. It states the name of the entity to which the funds need to be transferred, along with the amount and date of payment. Banker’s acceptances are short-term instruments that generally come with a maturity between 30 days and 180 days.
A banker’s acceptance is a short-term financial instrument that represents a promised future payment from a bank and with a maturity of between 30 and 180 days.
The application process for a banker’s acceptance is similar to that of a short-term loan and involves various credit and collateral checks.
Once the bank accepts a banker’s acceptance, the liability immediately transfers from the issuer of the banker’s acceptance to the bank.
How Does a Banker’s Acceptance Work?
The issuer of a banker’s acceptance deposits the future payment with a bank. The bank charges a small fee and issues a time draft against the deposit, representing a guaranteed future payment by the bank. Upon acceptance from the bank, the liability transfers from the issuer of the banker’s acceptance and becomes an obligation of the bank. As such, the credit rating of a banker’s acceptance is generally the same as that of the bank that promised the payment.
Since banker’s acceptances are short-term instruments, the application process for the securities is similar to that of short-term loans. The bank will assess the creditworthiness of the borrower using its internally set criteria to ensure that the borrower holds sufficient funds to cover the deposit for the future payment. Depending on the size of the banker’s acceptance, the borrower may or may or not need to provide collateral. The bank charges the borrower a small percentage on the amount.
Banker’s Acceptance vs. Time Drafts
A banker’s acceptance essentially serves the same purpose as time drafts and postdated checks. The key difference is that a banker’s acceptance can be traded in the secondary market before maturity and is thus seen as an investment tool.
Another difference is the way the instruments are used. Unlike time drafts, banker’s acceptances are frequently used in international trade. Due to the bank’s guarantee, a banker’s acceptance substantially reduces the risk of not receiving the payment for the seller.
It is especially important when there is not a strong relationship between the buyer and seller. As a result, banker’s acceptances are commonly used by importing and exporting businesses, where the importer issues the banker’s acceptance to pay the exporter.
Banker’s Acceptance as an Investment
Banker’s acceptances are exchanged in a liquid secondary market and are traded like debt instruments. The instruments are traded through banks and securities dealers and cannot be purchased on an exchange. Since a banker’s acceptance does not provide the holder with a coupon payment, it always trades at a discount to its face value.
The difference between the face value and the price represents the return or yield the buyer will receive. The holder of a banker’s acceptance can either hold the instrument until maturity and receive the face value of the security or sell the security before its maturity, at a discount. The strategy is similar to the one involved in trading zero-coupon bonds.
The price of these securities is often negotiated with the buyers and is largely influenced by the credit rating of the bank that promised the payment. Since the instruments promise a payment from a financial institution, they are considered relatively safe.
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