What Is a Back to Back Loan Agreement

A U.S. company that wants to open an office in China and a Chinese company that wants to open a U.S. company can both take out a consecutive loan. In the manner of Laon, the American company can lend the Chinese company $ 2 million to open an office in America, while the Chinese company would also lend the American company the equivalent of $ 2 million. Due to the fact that both loans are issued in their excellent currencies, both companies will be able to hedge currency risks. However, both loans have the same maturity date, they are repaid on the same day. The risk of default is therefore a problem, since the failure of one party to repay the loan on time does not release the obligations of the other party. As a rule, this risk is offset by another financial arrangement or by an emergency clause included in the original loan agreement. The company and the bank agree on a one-year term of the loan and an interest rate of 4%. At the end of the loan term, the company repays the loan at the fixed interest rate agreed at the beginning of the loan term, thereby guaranteeing foreign exchange risk for the term of the loan. Another example would be the financing of Canadian companies financed by a German bank. The company is concerned that the value of the Canadian dollar will change against the euro.

Therefore, the company and the bank create a back-to-back loan in which the company deposits C$1 million with the bank, and the bank (which uses the deposit as security) lends the company a value of C$1 million based on the current exchange rate. Most back-to-back loans mature within 10 years because of their inherent risks. The greatest risk in such agreements is asymmetric liability, unless explicitly covered in the back-to-back loan agreement. This liability arises when one party defaults on the loan and the other party remains responsible for repayment. To mitigate this problem, XYZ Company and ABC Bank structure a consecutive loan in which XYZ Company deposits $1 million with ABC Bank, and ABC Bank (which uses the deposit as collateral) lends $1 million to XYZ Company. The current exchange rate between the US dollar and the euro is 1:0.50 (i.e. $1 buys half a euro). Although our example is two relatively stable currencies, back-to-back loans are most often unstable currencies (due to their high volatility, making it more necessary for companies in these countries to mitigate their currency risk). Most back-to-back loans mature within 10 years because of their inherent risks.

[1] Initiated to circumvent currency regulation, this practice had been largely replaced by cross-currency swaps in the mid-1990s. [2] In consecutive loans, two parties, each in a different country, lend money to each other to hedge against currency risks. They are also known as “parallel loans”. A back-to-back loan, also known as a parallel loan, is when two companies from different countries borrow counterparties from each other in each other`s currency to hedge against currency risks. Although currencies remain in place and interest rates (based on each region`s trading rates) remain separate, each loan has the same maturity date. Usually, when a company needs to access money in another currency, it trades it on the foreign exchange market. However, because the value of some currencies can fluctuate considerably, a company may unexpectedly pay much more for a particular currency than expected. Companies with overseas operations can try to reduce this risk with a consecutive loan.

A disadvantage of such agreements is asymmetric liability – if no specific agreement is reached, if one party defaults on the loan, the other party can still be held responsible for repayment. [3] Another disadvantage compared to cross-currency swaps is that back-to-back lending transactions are generally recorded as liabilities in the records of banking institutions, which increases their capitalization requirements, whereas cross-currency swaps were largely exempt from this requirement in the 2000s. [3] A back-to-back loan is a loan agreement between two companies based in different countries where one bank grants a loan in advance based on the loan granted by the other bank in another country. Each of these companies lends each other loans in its different currencies. The currencies and interest rates of the two companies in a consecutive loan are different, but both loans have the same maturity date. .