What is a letter of guarantee
A letter of guarantee is a type of contract issued by a bank on behalf of a customer who has entered into a contract to purchase goods from a supplier. The letter of guarantee informs the supplier that he will be paid, even in the event of default by the bank’s client. To obtain a letter of guarantee, the client will have to request it, as for a loan. If the bank is comfortable with the risk, it will support the client with the letter, for an annual fee.
A letter of guarantee can also be issued by a bank on behalf of a subscriber guaranteeing that the subscriber owns the underlying asset and that the bank will deliver the underlying securities if the call is made. Call writers often use a letter of guarantee when the underlying asset of a call option is not held in their brokerage account.
Basic principles of the letter of guarantee
Letters of guarantee are often used when one party to a transaction is unsure whether the other party involved can meet its financial obligations. This is particularly common with purchases of expensive equipment or other goods. However, a letter of guarantee may not cover the entire amount of the debt. For example, a letter of guarantee in a bond issue can promise either interest or principal, but not both.
The bank will negotiate the amount it will cover with its client. Banks charge a year for this service, which is generally a percentage of the amount the bank may owe in the event of default by their customer.
Letters of guarantee are used in a wide variety of business situations. These include contracts and construction, financing a financial institution or declarations during the export and import processes.
Letter of guarantee for a call writer
Since many institutional investors hold investment accounts in depository banks rather than with brokers, a broker often accepts a letter of guarantee for call calls with short options instead of holding cash or securities . The letter of guarantee must be presented in a form accepted by the stock exchange, and possibly the Clearing Corporation. The issuing bank undertakes to deliver the underlying securities to the broker if the call call account is allocated.
Example of letter of guarantee
Suppose the company XYZ buys large custom equipment for their store at a cost of $ 1 million. The equipment supplier will need to manufacture it and may not be ready for several months. The buyer does not want to pay at the moment, but the supplier also does not want to devote time and resources to building this equipment without guarantee that this buyer will buy it and have the resources to buy it. The buyer can contact his bank and obtain a letter of guarantee. This should help appease this supplier, as the bank supports the buyer.
Suppose a call writer has 10 short AAAA fictitious share contracts. This equals 1000 actions. If the stock price goes up, these short buy positions will lose money, and since there is no cap on the extent to which a security can go up, the loss could theoretically be infinite. But if the caller holds 1,000 shares, the risk is mitigated. It is a covered call.
In order to shorten the contracts in the first place, the writer may have had to produce a letter of guarantee showing that they own the stock (in another account, otherwise the broker would not need the letter), because the broker may have viewed the short call overdraft as too risky.