What a bank guarantee promises a buyer and what it costs the factory to hold

This page teaches what a bank guarantee actually promises a buyer, and what it costs a factory to hold one open, for anyone deciding whether an order needs one

A bank guarantee is a bank's own promise to pay a buyer up to a fixed amount if the factory fails to meet its own contract obligation, for example failing to deliver, or failing to repay an advance payment already received. It is not a currency instrument; a purely domestic order, priced and paid entirely in one currency with no foreign exchange risk at all, can still need a bank guarantee, because the risk a guarantee covers is delivery or repayment failure, not a currency move. Holding a guarantee open is not free: the factory pays its own bank a fee for as long as the guarantee stands. This lesson mainly teaches the money flow: what a guarantee promises, and what its own fee costs the factory that holds it.

What you need, and what this lesson does not cover

You need: the idea, from Track 15, Course 1, that a payment method sits somewhere on a risk spectrum between buyer and factory; a bank guarantee is one tool used to shift that risk.

By the end of this lesson you can:

• state what a bank guarantee promises the party holding it, and who pays for it;
• distinguish a bank guarantee from a currency hedge, and explain why a domestic order can still need one;
• name two common guarantee types and what each protects against;
• calculate, on an illustrative fee rate and amount, what a guarantee costs a factory to hold for a given period;
• recognise when a guarantee's own cost is worth the certainty it buys the other side.

Not covered here: the currency exposure this course covered in lessons 6.1 and 6.2, and building a complete financial risk sheet for a new order (lesson 6.4).

Words you will meet in this lesson

A bank guarantee protects the party holding it against the factory's own failure to perform, and the factory pays its own bank a fee for as long as that promise stands open

A bank guarantee is not the buyer paying more; it is the factory's own bank standing behind the factory's promise, so that if the factory fails, the bank pays instead, up to the guaranteed amount. The factory pays for this protection, usually as a percentage of the guaranteed amount per year, for as long as the guarantee remains open. A guarantee is not tied to a currency move at all; it protects against delivery failure or against a factory failing to repay an advance already received, a risk that exists whether the order is export or purely domestic.

Which guarantee type applies, and how large its fee is, depends on what risk the other side wants covered and how the order itself is structured

Cedar & Co. asks Delta Garments to back a large new forecast order with a performance guarantee, even though the sale is entirely domestic

Cedar & Co., Delta Garments' own domestic buyer on 60-day open account, plans an unusually large Make to Stock order ahead of a new season, sized well beyond its usual forecast. To protect itself against Delta Garments failing to deliver on time against this larger commitment, Cedar & Co. asks Delta Garments to back the order with a performance guarantee from its own bank, illustrative amount USD 50,000 local-currency equivalent, for the six months the forecast order is expected to take from confirmation to full delivery. No currency is involved on either side; both Cedar & Co. and Delta Garments deal entirely in local currency.

An illustrative fee rate of 2% per year, held for six months, costs Delta Garments a known amount to hold Cedar & Co.'s performance guarantee open

Decide whether an order needs a bank guarantee, and what it will cost, in four steps

1. Name the risk the other side wants covered: delivery failure, or failure to repay an advance already received.
2. Choose the matching guarantee type, performance or advance payment, rather than one covering a different risk.
3. Size the guaranteed amount to what is genuinely at risk on this order, and the period to how long the risk actually runs.
4. Calculate the fee, amount times annual rate times the fraction of a year held open, and weigh it against the business the guarantee protects.

A common mistake is assuming a bank guarantee is only needed on export orders, since export financing is where the term is most often heard

A performance guarantee or an advance payment guarantee is a promise about delivery or repayment, not about currency, so nothing about it requires a foreign buyer or a foreign-currency price. Cedar & Co.'s own domestic order shows the same instrument used for the same reason, protecting a buyer against a factory's own failure to perform, with no exchange rate anywhere in the arrangement. A factory that assumes guarantees are an export-only concern may be caught unprepared when a large domestic buyer, protecting its own larger commitment, asks for exactly the same instrument.

• A bank guarantee protects the buyer against the factory's own failure to deliver or repay, not against a currency move.
• The factory pays its own bank a fee for as long as the guarantee stays open, whether or not it is ever called on.
• A performance guarantee and an advance payment guarantee protect against two different failures.
• A domestic order can need a guarantee just as reasonably as an export order.
• Guarantee fee cost is guaranteed amount times annual rate times the fraction of a year held open.
• Size the guaranteed amount and period to what is genuinely at risk on the order in front of you.

Delta Garments' owner questions why Cedar & Co., a domestic buyer paid in the same currency, is asking for a bank guarantee at all

Delta Garments' owner reviews Cedar & Co.'s request for a performance guarantee on the large new forecast order. Since Cedar & Co. pays in the same local currency Delta Garments already uses, with no currency involved anywhere in the arrangement, the owner questions whether a guarantee is really necessary here.

Here is the request Omar sent from Cedar & Co.:

Is Cedar & Co.'s request reasonable, even though no currency risk is involved? Decide before opening the answer.

Financial risk sheet: record a guarantee's own amount, fee rate and period to calculate its cost

Open the Financial risk sheet workbook linked below. Its "Guarantee cost" sheet lists the guaranteed amount, the illustrative annual fee rate and the guarantee period, and calculates the fee cost this lesson worked through. Fill in the yellow "Your order" column with your own order's own figures to see what a guarantee would cost to hold on it.

[Download the Financial risk sheet](../../templates/T15-C06-financial-risk-sheet.xlsx)

Download the Financial risk sheet (Excel)

Lesson 6.4: Building a complete financial risk sheet for a new export order

You now know what a bank guarantee promises and what it costs a factory to hold, on both an export order and a purely domestic one. The final lesson brings currency exposure and guarantee cost together into one complete financial risk sheet for a new order. Back to the course map