A back-to-back loan is an arrangement between two entities in different countries that act as a hedge against currency risk. In this type of loan, both parties borrow the offsetting amounts from one another in the other party's currency.
Also called parallel loans, they are a popular trading technique amongst companies trying to protect themselves from currency risks. Let us take a deeper look at back-to-back loans - how to use them and associated risks.
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What is a Back-to-back Loan?
A back-to-back loan is an agreement between two companies to different domiciles where they borrow offsetting amounts from each other in the other's currency. This helps them settle bills in that currency easily.
Back-to-back trading helps companies avoid currency risk, price fluctuations, and other restrictions it may have otherwise countered.
Explanation of Back-to-back Loan
Back-to-back meaning in business is explained through the need to cut short a lengthy and risky process. When a company needs to deal in another currency, be it for paying bills or investing in a project, it will trade for it in the Forex market. The process involves more risk and less credit. A back-to-back loan acts as a superior alternative. A company can make a deal with a company in the country of its interest.
By borrowing offsetting amounts to be paid at the same maturity date, both companies are able to deal in the other currency without having to go through the lengthy process of dealing in the Forex market.
Why and How is a Back-to-back Loan Used?
With the back-to-back loan explained above, you can infer that the purpose of using a back-to-back loan is to have a safe and quick way to deal with foreign currency. It acts as a hedge against currency risk while offering more credit. It is especially useful if the currency you wish to trade-in is a smaller currency that may not have much liquidity compared to the major ones.
To use a back-to-back loan, you will have to enter into an agreement with a company in the domicile of currency you need to operate it. Both companies will exchange a back-to-back letter of credit with the same maturity date set. At the maturity date, both companies will receive the amount in the other currency to be traded. Fluctuations in the market will not affect the price, making it a risk-free and quick method as opposed to the Forex market.
The benefits of back-to-back loans include:
• Hedge against currency risk
• Fast and convenient
• Great for currencies that are unstable or of low liquidity
Examples of Back-to-back Loan
A back-to-back loan example can be seen through an American Company and a Japanese company wanting to invest in the other's country.
1 USD is approximately equal to one Japanese Yen. Now, the American company gives the Japanese company 10,000 USD to facilitate its investment. The amount is given in USD.
This amounts to 12,94,170 Japanese Yen. The Japanese company gives 12,94,170 Japanese Yen to the American company. The amount is given in Japanese Yen.
Both amounts are transacted at the same time and dealt with in local currencies, making them immune to currency risk.
What are the Risks of a Back-to-back Loan?
While back-to-back loans are an effective way to trade in foreign currency in a quick and easy way, there are some risks it possesses that you should consider. Here are the most prominent back-to-back loan risks:
a) Difficulty in finding a suitable partner - It can often be hard to find a company in your country of interest that has the same funding needs as you. Most companies end up compromising on their needs to make the deal work.
b) If a broker gets involved - If a broker is involved, then their brokerage fees get added to your costs. Most companies would not want to involve a broker but are forced to due to the difficulty in finding companies with similar needs.
c) Inherent risks - Asymmetrical liability occurs when one party defaults on the loan and it leaves the other party responsible for payment.
Default risk leaves the other party still liable upon the failure of one party. These inherent risks amount to the disadvantages of back-to-back loans that need to be covered in the contingency clause of the loan agreement.
Conclusion
Back-to-back loans or parallel loans are an arrangement between two companies in different countries. They borrow offsetting amounts from one another in the other's currency to invest in their market. This method shields them from the currency risk of the Forex market while also being fast and convenient.
It is a good option for you if you can find a party in the country of interest that has similar investing goals as you. Make sure to cover contingencies in the contract that protect you against the default risk.
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FAQs
1. What is the limit on back-to-back loans?
While there is no explicit limit on back-to-back loans, they usually become due in around 10 years as a result of inherent risks they carry.
2. What is a back-to-back deal?
A back-to-back deal involves two parent companies borrowing offsetting amounts in the other company's local currency and then lending it to the other company's local subsidiary in their own country.
For example, if a Japanese and American company enters the deal, the Japanese company will hand over the amount in Japanese Yen to the local subsidiary of the American company in Japan and vice versa.
3. What is a back-to-back letter of credit?
A back-to-back letter of credit is a letter that acknowledges and secures the deal between two companies.