How do you use a back-to-back loan?

By Chizoba Morah AAA
A:

Back-to-back loans or parallel loans are a financial move used by companies to curb foreign exchange rate risk or currency risk. They are loan arrangements where companies loan each other money in their own currency. For example, if a U.S. company is engaged in a back-to-back loan arrangement with a Mexican company, the U.S. company borrows pesos from that company, while the same company borrows dollars from the U.S. company.

Usually, if a company needs money in another currency, the company heads to the currency market to trade for it. The issue with trading currency is that a currency with high fluctuations can result in great loss for the company. A back-to-back loan is very convenient for a company that needs money in a currency that is very unstable. When companies engage in back-to-back loans, they usually agree on a fixed spot exchange rate, usually the current one. This eliminates the risk associated with the volatility of exchange rates because the companies are repaying their loans based on the agreed upon fixed rate.

This is how back-to-back loans work: To avoid currency or exchange risk, companies look for other companies in another country and engage in back-to-back loaning. For example, if U.S company X, has a subsidiary in Japan, Y, that needs one thousand yen, company X will look for a Japanese company with a subsidiary in the U.S., Z, that needs one thousand dollars. A back-to-back loan occurs when company X loans Z $1000 and the Japanese company loans Y, ¥1000. The two companies usually agree on the duration of the loan and at the end of the loan term, they swap currencies again. Back-to-back loans are rarely used today but they still remain an option for companies seeking to borrow foreign currency.

For more on exchange risk, see Foreign Exchange Risk.

This question was answered by Chizoba Morah.

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