A draft, sometimes referred to as a bill of exchange, is the instrument normally used in international commerce to effect payment. A draft is simply an order written by an exporter instructing an importer, or an importer’s agent, to pay a specified amount of money at a specified time. In the example of the U.S. exporter and the French importer, the exporter writes a draft that instructs the Bank of Paris, the French importer’s agent, to pay for the merchandise shipped to France. The person or business initiating the draft is known as the maker (in this case, the U.S. exporter). The party to whom the draft is presented is known as the drawee (in this case, the Bank of Paris).
Bill of Exchange
An order written by an exporter instructing an importer, or an importer’s agent, to pay a specified amount of money at a specified time.
See Bill of exchange.
International practice is to use drafts to settle trade transactions. This differs from domestic practice in which a seller usually ships merchandise on an open account, followed by a commercial invoice that specifies the amount due and the terms of payment. In domestic transactions, the buyer can often obtain possession of the merchandise without signing a formal document acknowledging his or her obligation to pay. In contrast, due to the lack of trust in international transactions, payment or a formal promise to pay is required before the buyer can obtain the merchandise.
Drafts fall into two categories, sight drafts and time drafts. A sight draft is payable on presentation to the drawee. A time draft allows for a delay in payment—normally 30, 60, 90, or 120 days. It is presented to the drawee, who signifies acceptance of it by writing or stamping a notice of acceptance on its face. Once accepted, the time draft becomes a promise to pay by the accepting party. When a time draft is drawn on and accepted by a bank, it is called a banker’s acceptance. When it is drawn on and accepted by a business firm, it is called a trade acceptance.
A draft payable on presentation to the drawee.
A promise to pay by the accepting party at some future date.
Time drafts are negotiable instruments; that is, once the draft is stamped with an acceptance, the maker can sell the draft to an investor at a discount from its face value. Imagine the agreement between the U.S. exporter and the French importer calls for the exporter to present the Bank of Paris (through the Bank of New York) with a time draft requiring payment 120 days after presentation. The Bank of Paris stamps the time draft with an acceptance. Imagine further that the draft is for $100,000.
The exporter can either hold onto the accepted time draft and receive $100,000 in 120 days or he can sell it to an investor, say, the Bank of New York, for a discount from the face value. If the prevailing discount rate is 7 percent, the exporter could receive $97,700 by selling it immediately (7 percent per year discount rate for 120 days for $100,000 equals $2,300, and $100,000 − $2,300 = $97,700). The Bank of New York would then collect the full $100,000 from the Bank of Paris in 120 days. The exporter might sell the accepted time draft immediately if he needed the funds to finance merchandise in transit and/or to cover cash flow shortfalls.