Very simply, a standby letter of credit (SBLC) has these characteristics:
- Buyer (e.g. ALCAN, an aluminum rolling mill)
- Seller (e.g. An aluminum recycling plant)
- Issuer (e.g. CanadaBank)
- Notional (e.g. 50M CAD)
- Expiry (6 months from now).
So in the happy path, Buyer pays seller at expiry for the whole notional amount, and the SBLC just gets discharged.
In the unhappy path, the Buyer does not pay the entire notional amount to the Seller. The seller, before expiry, claims the rest, which the Issuer pays. In the end, the Buyer has a debt to the Issuer.
I can think of two options:
Represent this as an Option, written by the Issuer, on who they intend to get paid by. Electing the Issuer to pay effectively represents a claim under the terms of the SBLC.
Represent only the happy path, as a liability from Buyer to Seller. Use a replacement event to represent the unhappy path, initiated by the Issuer. This will create a payment to the Seller and a liability to the Buyer.
On your option 1, I believe the option should be written by the
seller on who they intend to get paid by (either the
buyer or the
At first glance, both options you describe seem sensible. I would favour the latter, as it seems to be closer to the economics of the instrument (the
buyer gets to choose, rather than the
What is unclear to me is how you would represent the option / liabilities in the finance library:
- using contingent claims for the option?
- using a token instrument for the liability?
An approach that comes to mind is the following:
Use contingent claims (generic instrument) to model the liability from
- The instrument would represent a promise to redeem 1 CAD on expiry date ( a simple
when (at maturity) $ one CAD would do)
- The buyer has a
Holding on the instrument for an amount equivalent to the notional amount of the SBLC
The buyer pays the seller either in units of USD or in units of SBLC instrument (holdings get transferred from buyer to seller)
If the seller has any units of SBLC at expiry, they will claim them against the
Bank (if the seller was paid entirely in cash, they would not hold any units of SBLC)