What Is a Back-to-Back Loan?
A back-to-back loan is an agreement by two companies in different countries to borrow money in each other’s currency. The effect is a currency exchange.
The back-to-back loan is a hedge against currency risk. Each company gets the currency it needs while avoiding untimely currency rate fluctuations in the open market.
The back-to-back loan is also known as a parallel loan.
Key Takeaways
- The purpose of a back-to-back loan is to avoid borrowing money in the forex market, where there could be adverse price fluctuations, restrictions, unwanted transparency, and fees.
- 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 loan strategy has greater credit or default risk than using the forex market.
How a Back-to-Back Loan Works
Companies that do business in other countries need to obtain money in other currencies for routine transactions. Normally, a company will trade on the forex for the currency it needs.
But because the values of some currencies fluctuate widely, a company can unexpectedly wind up paying far more for a given currency than it had expected. Companies with operations abroad may seek to reduce this risk with a back-to-back loan.
Companies could accomplish the same hedging strategy by trading in the currency markets, either cash or futures. These days, currency swaps and similar instruments have largely replaced back-to-back loans. But some companies still rely on back-to-back loans to facilitate international trade.
Benefits of Back-to-Back Loans
One benefit of the back-to-back loan is that any currency can be exchanged this way. Only a few major currencies regularly trade in the futures markets in a high enough volume to facilitate efficient trade.
Back-to-back loans often involve currencies that are unstable or trade in low volume. High volatility in such trading creates a greater need among companies doing business in those countries to mitigate their currency risk.
Back-to-back loans, although not without risks, are generally more convenient and less risky than obtaining currency through the market.
Back-to-Back Loan Risks
The biggest problem companies face in arranging back-to-back loans is finding counterparties with similar funding needs. Even if they find appropriate partners, the terms and conditions of the two parties may not match. Some parties enlist the services of a broker, but brokerage fees add 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, which may not be 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 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 in low volumes.
Back-to-Back Loan Examples
Say an American company wishes to open a European office and a European company wishes to open an American office. Each party needs to exchange money to pay for leasing and other startup costs in the local currency.
The American company may lend the European company $1 million for initial leasing and other costs. Simultaneously, the European company lends the American company the equivalent of $1 million in euros at the current exchange rate.
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 obtaining financing through a German bank. The company is concerned about the value of the Canadian dollar relative to the euro.
The company and the bank can create a back-to-back loan. 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.
What Is a Back-to-Back Loan in Banking?
A back-to-back loan is an agreement between two parties in two countries, One of those parties is often a bank. The other is a company doing business in the bank’s home country, and in need of local currency.
The purpose of the loan is to facilitate a currency exchange. The company will loan the bank a sum of money in its own home currency. The bank will then deposit an equivalent sum in its currency with the company.
The company will pay a set interest amount on the loan at a set future date.
What Is a Back-to-Back Commitment?
A back-to-back commitment is different from the back-to-back loan used to exchange foreign currencies.
A back-to-back commitment is an arrangement with a bank to extend a loan which will be paid off with a second loan from the same bank or another bank.
The back-to-back commitment is common in the construction industry, where one uncollateralized loan is needed to finance construction and a second, using the newly-built structure as collateral, is needed to finance marketing.
What Does Back-to-Back Mean in the Sale of Commodities?
A back-to-back sale is a transaction completed by a company that does not yet own or possess the goods it is selling. The goods may be at a vendor’s warehouse or in transit. The seller can then redirect the goods to the purchaser to fulfill the order. This process is particularly common in the sale of commodities such as produce, where fast delivery is essential.
The Bottom Line
Back-to-back loans are not as common as they once were, given the availability of currency swaps and other strategies to mitigate currency risk in international trading.
Still, some companies still rely on this system to give them relatively easy and safe access to the foreign currencies they need to conduct business abroad.
