Back-to-Back Loan
What Is a Back-to-Back Loan?
A back-to-back loan, otherwise called a parallel loan, is when two companies in various countries borrow offsetting sums from one more in one another's currency as a hedge against currency risk. While the currencies and interest rates (in view of the commercial rates of every district) stay separate, each loan will have a similar maturity date.
Companies could achieve a similar hedging strategy by trading in the currency markets, either cash or futures, yet back-to-back loans can be more helpful. Nowadays, currency swaps and comparative instruments have to a great extent supplanted back-to-back loans. No different either way, these instruments actually work with international trade.
How a Back-to-Back Loan Works
Typically, when a company needs access to money in another currency it trades for it on the currency market. But since the value of certain currencies can vary widely, a company can unexpectedly end up paying definitely more for a given currency than it had expected to pay. Companies with operations abroad may look to reduce this risk with a back-to-back loan.
The benefits of back-to-back loans remember hedging for the specific currencies required. Just major currencies trade in the futures markets or have enough liquidity in the cash markets to work with efficient trade. Back-to-back loans most usually include currencies that are either shaky or trade with low liquidity. High volatility in such trading makes greater need among companies in those countries to relieve their currency risk.
Back-to-Back Loan Risks
In chasing after back-to-back loans, the most serious issue companies face is finding counterparties with comparative funding needs. Also, even assuming they truly do find proper partners, the terms and conditions wanted by both may not match. A few gatherings will enroll the services of a broker, however at that point brokerage fees must be added to the cost of the financing.
Most back-to-back loans come due in the span of 10 years due to their inherent risks. The most serious risk in such agreements is asymmetrical liability, except if it is explicitly covered in the back-to-back loan agreement. This liability emerges when one party defaults on the loan leaving the other party still responsible for repayment.
Default risk is hence a problem, as a disappointment by one party to pay back the loan promptly doesn't release the obligations of the other party. Commonly, this risk is offset by another financial agreement, or by a contingency clause covered in the original loan agreement.
Back-to-back loans most usually include currencies that are either unsteady or trade with low liquidity.
Back-to-Back Loan Example
One model would be an American company wishing to open an European office and an European company wishing to open an American office. The American company might loan the European company $1 million for initial leasing and different costs. This loan is calculated in U.S. dollars. All the while, the European company loans the American company the equivalent of $1 million in euros at the current exchange rate to assist with its leasing and different costs. Since the two loans are made in the neighborhood currencies, there is no currency risk (the risk that the exchange rates between two currencies will swing widely) when the loans are paid back.
Another model would be a Canadian company financing through a German bank. The company is worried about the value of the Canadian dollar changing relative to the euro. Thusly, the company and the bank make a back-to-back loan, by which the company deposits CA$1 million with the bank, and the bank (involving the deposit as security) loans the company CA$1 million worth of euros in light of the current exchange rate.
The company and the bank consent to a one-year term on the loan and a 4% interest rate. At the point when the loan term closes, the company repays the loan at the fixed rate agreed upon toward the beginning of the loan term, subsequently guaranteeing against currency risk during the term of the loan.
Highlights
- Since various loans are originated, a back-to-back strategy has greater credit or default risk than utilizing the forex market.
- A back-to-back loan is an agreement wherein two parent companies in various countries borrow offsetting sums in their nearby currencies, then, at that point, loan that money to the next's neighborhood subsidiary.
- By hosting each gathering borrow funds in its home currency, a back-to-back loan looks to keep away from exchange risk — an adverse change in exchange rates between two currencies.
- The purpose of a back-to-back loan is to try not to borrow money across country lines with the price vacillations, potential limitations, undesirable transparency, and fees associated with forex markets.
