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



A:

Back-to-back loans, also called 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 Mexican 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.

Avoiding Currency Risk

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 lending. For example, if U.S company X, has a subsidiary in Japan, Y, that needs 1,000 yen, company X will look for a Japanese company with a subsidiary in the U.S., Z, that needs $1,000. A back-to-back loan occurs when company X loans Z $1,000 and the Japanese company loans Y 1,000 yen. 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.

Although back-to-back loans have been around since at least the 18th century, they really only gained prominence in the 1970s when companies in the U.K. used them to avoid stiff foreign investment taxes. They have fallen out of usage today in favor of currency swaps and foreign exchange derivatives. In a currency swap, the actual principal amount isn’t swapped, but used to calculate interest payments paid to each party. The companies are not required to list these foreign exchange transactions on the balance sheet. (See also: Foreign Exchange Risk.)

This question was answered by Chizoba Morah.



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