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Trade finance

It refers to the various terms of financial support and financial transactions used in international trade. Trade finance uses a range of instruments to provide finance to exporters and importers, including documentary credits such as letters of credit.

It’s a science that describes the management of money, banking, credit, investments and assets for international trade transactions.
It is the mechanisms by which firms engaged in trade cover its costs, including borrowing, forfaiting, etc. It is an imprecise term covering a number of different activities like seasonal and stocking finance, as well as import and export finance and funding for large one-off transactions. Financial techniques used to fund the manufacture, sale and delivery of goods to foreign buyers. Trade finance also includes techniques that are used to monetize accounts receivables that result from international commercial transactions.

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Letter of credit

Letter of Credit is abbreviated as an LC or L/C, and often is referred to as a documentary credit, abbreviated as DC or D/C, documentary letter of credit, or simply as credit.

It’s a document issued mostly by a financial institution, used primarily in trade finance, which usually provides an irrevocable payment undertaking, it can also be revocable, confirmed, unconfirmed, transferable or others e.g. back to back: revolving but is most commonly irrevocable/confirmed to a beneficiary against complying documents as stated in the Letter of Credit.
Once the beneficiary or a presenting bank acting on its behalf, presents to the issuing bank or confirming bank, if any, on or before the expiry date of the LC, documents complying with the terms and conditions of the LC, the applicable UCP and international standard banking practice, the issuing bank or confirming bank, if any, is obliged to honour irrespective of any instructions from the applicant to the contrary.

Letters of credit are used primarily in international trade transactions of significant value, for deals between a supplier in one country and a customer in another. They are also used in the land development process to ensure that approved public facilities (streets, sidewalks, stormwater ponds, etc.) will be built.

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Credit Enhancement

It encompasses a variety of provisions that may be used to reduce the credit risk of an obligation. Credit enhancements are often incorporated into OTC derivatives, corporate debt, securitized debt and other instruments.

Credit enhancement is a key part of the securitization transaction in structured finance, and is important for CRA (Credit Rating Agencies) when rating a securitization.
Techniques of credit enhancement include Collateralization, third party loan guarantees, credit insurance, and credit letter.
Other techniques may sometimes also be referred to as credit enhancement. These include netting agreements, credit downgrade triggers, and bundling with credit derivatives.

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Tranche

Tranche is one of a number of related securities offered as part of the same transaction in structured finance but the term’s use in structured finance may be singled out as particularly important.

The term “tranche” is used in fields of finance other than structured finance. Tranche stands for series, portion, section or slice. From the financial point of view each and every bond is a different slice of the deal’s risk. In the world of investing, it is used to describe a security that can be split up into smaller pieces and subsequently sold to investors.
Tranche can be defined as different classes which can be identified by letters as Class A, Class B, Class C securities.

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CDO

CDOs are constructed from a portfolio of fixed income assets. CDOs are divided by the issuer into different tranches: senior tranches (rated AAA), mezzanine tranches (AA to BB), and equity tranches (unrated) It’s an asset backed security (ABS) and structured credit product.
Losses are applied in reverse order of seniority and so junior tranches offer higher coupons “interest rates” to compensate for the added default risk. CDOs have become an important funding vehicle for fixed-income assets.

During the credit bubble of the mid-2000s, a few academics, analysts and investors such warned that financial derivatives such as CDOs and other ABSes were greatly increasing risk in the financial markets, but their views were dismissed. With the advent of the 2007-2008 credit crunch, it has become clear that CDOs, like all ABSes, suffer from a fundamental flaw that causes all tranches to be extremely high risk for investors.