What Is a Back-to-Back Loan?
A back-to-back loan, also known as a parallel loan, is when two companies in different countries borrow offsetting amounts from one another in each other's currency as a hedge against currency risk. While the currencies remain and interest rates (based on the commercial rates of each locale) remain separate, each loan will have the same maturity date.
Companies could accomplish the same hedging strategy by trading in the currency markets, either cash or futures, but back-to-back loans can be more convenient. These days, currency swaps and similar instruments have largely replaced back-to-back loans. All the same, these instruments still facilitate international trade.
- A back-to-back loan is an agreement in which two parent companies in different countries borrow offsetting amounts in their local currencies, then lend that money to the other's local subsidiary.
- The purpose of a back-to-back loan is to avoid borrowing money across country lines with the price fluctuations, possible restrictions, unwanted transparency, and fees associated with forex markets.
- By having each party borrow funds in its home currency, a back-to-back loan seeks to avoid exchange risk—an adverse change in exchange rates between two currencies.
- Because multiple loans are originated, a back-to-back strategy has greater credit or default risk than using the forex market.
How a Back-to-Back Loan Works
Normally, when a company needs access to money in another currency it trades for it on the currency market. But because the value of some currencies can fluctuate widely, a company can unexpectedly wind up paying far more for a given currency than it had expected to pay. Companies with operations abroad may seek to reduce this risk with a back-to-back loan.
The benefits of back-to-back loans include hedging in the exact currencies needed. Only major currencies trade in the futures markets or have enough liquidity in the cash markets to facilitate efficient trade. Back-to-back loans most commonly involve currencies that are either unstable or trade with low liquidity. High volatility in such trading creates greater need among companies in those countries to mitigate their currency risk.
Back-to-Back Loan Risks
In pursuing back-to-back loans, the biggest problem companies face is finding counterparties with similar funding needs. And even if they do find appropriate partners, the terms and conditions desired by both may not match. Some parties will enlist the services of a broker, but then brokerage fees have to be added to the cost of the financing.
Most back-to-back loans come due within 10 years because of their inherent risks. The greatest risk in such agreements is asymmetrical liability, unless it is specifically covered in the back-to-back loan agreement. This liability arises when one party defaults on the loan leaving the other party still responsible for repayment.
Default risk is thus a problem, as a failure by one party to pay back the loan in a timely manner does not release the obligations of the other party. Typically, this risk is offset by another financial agreement, or by a contingency clause covered in the original loan agreement.
Back-to-back loans most commonly involve currencies that are either unstable or trade with low liquidity.
Back-to-Back Loan Example
One example would be an American company wishing to open a European office and a European company wishing to open an American office. The American company may lend the European company $1 million for initial leasing and other costs. This loan is calculated in U.S. dollars. Simultaneously, the European company lends the American company the equivalent of $1 million in euros at the current exchange rate to help with its leasing and other costs. Because both loans are made in the local 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 example would be a Canadian company financing through a German bank. The company is concerned about the value of the Canadian dollar changing relative to the euro. Therefore, the company and the bank create a back-to-back loan, whereby the company deposits CA$1 million with the bank, and the bank (using the deposit as security) lends the company CA$1 million worth of euros based on the current exchange rate.
The company and the bank agree to a one-year term on the loan and a 4% interest rate. When the loan term ends, the company repays the loan at the fixed rate agreed upon at the beginning of the loan term, thereby ensuring against currency risk during the term of the loan.