A letter of guarantee is a type of contract issued by a bank on behalf of a customer who has entered a contract to purchase goods from a supplier. The letter of guarantee lets the supplier know that they will be paid, even if the customer of the bank defaults. To get a letter of guarantee, the customer will need to apply for it, similar to a loan. If the bank is comfortable with the risk, they will back the customer with the letter, for an annual fee.
A letter of guarantee may also be issued by a bank on behalf of a call writer guaranteeing that the writer owns the underlying asset and that the bank will deliver the underlying securities should the call be exercised. Call writers will often use a letter of guarantee when the underlying asset of a call option is not held in their brokerage account.
Letters of guarantee are often used when one party in a transaction is uncertain that the other party involved can meet their financial obligation. This is especially common with purchases of costly equipment or other property. However, a letter of guarantee may not cover the whole amount of the debt. For example, a letter of guarantee in a bond issue may promise either interest or principal repayment, but not both.
The bank will negotiate how much they will cover with their client. Banks charge an annual for this service, which is typically a percentage of how much the bank may owe if their client defaults.
Letters of guarantee are used in a wide variety of business situations. These include contracting and construction, financing from a financial institution, or declarations during export and import processes.