Tuesday, January 5, 2010

What is a Banker’s Acceptance?

As we have seen in an earlier post, the Banker’s Acceptance is one of the instruments traded in the money market.

It is simply an instruments that are used by companies to obtain funds. It is generally cheaper than loans or overdraft.

Let us take the examples below to understand how it works.

A company needs money to buy goods for the Christmas season and want to obtain funds from the bank and will pay back the money after Christmas. This company generally needs to pay cash especially if it is buying goods abroad where companies do not want to take the risk to give goods on credit.

The company will approach his bank and will enter into an agreement according to the sequence below.

1. The company approach the bank to enquire about the discount rate on BAs.

2. The BA will have a face value that the company will have to pay after a specific period of time. Likewise any investor that have bought the BA on the secondary market and who will present the BA to the bank at maturity will receive the face value as indicated on the BA.

The BA will also contain the commission that the bank will take from the company. Hence the bank will pay the company the face value minus the commission. If the face value is $ 1 million and the commission of the bank is $ 20000 then the company will receive only $ 980 000. 

3. If the bank accepts this agreement it will endorse it. Hence the name of Banker’s Acceptance. If the bank has accepted the agreement it would have to pay the face value of the BA to the holder of the BA at maturity.

4. The bank will then sell the BA on the secondary market where it will be traded until it reaches maturity.

5. At maturity the company will pay back the face value of the BA to the bank. However even if this does not happen, the bank will have to pay the holder the face value.

However I would still discourage small investors from investing directly in the money market. It is much better to invest in a  money market mutual fund.

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