Back-to-Back Loan - Explained
What is a Back-to-Back Loan?
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Table of ContentsWhat is a Back-to-Back Loan?How Does a Back-to-Back Loan Work?Back-to-Back Loan ExampleBack-to-Back Loan Risks
What is a Back-to-Back Loan?
A back-to-back loan is a loan agreement between two companies domiciled in different countries in which a bank advances a loan based on the loan advanced by the other bank in another country. Each of these companies borrows from one another in their different currencies. The currencies and interest rates of both companies in a back-to-back loan differ but both loans have the same maturity date. The gross interest of this type of loan is determined by the commercial rates of each location (country) but the maturity date for the loans are the same. A back-to-back loan is otherwise called a parallel loan.
How Does a Back-to-Back Loan Work?
When two companies in different countries need to access money in each others currency for the purpose of offsetting a bill or trading on the currency market, a back-to-back loan is used. Since the value of currencies differ, companies engage in this type of loan as a hedge against currency risk. Also, if a company takes a loan in another currency for the purpose of making a payment, it can minimize the expense the company would have accrued if it had paid in its own currency. Only large companies that have sufficient liquidity in the cash markets or countries whose currencies trade in future markets can participate in a back-to-back loan. Companies also reduce their currency risk using the back-to-back loan.
Back-to-Back Loan Example
An American company that desires to open an office in China and a Chinese company that wishes to open a American company can both engage in back-to-back loan. In the type 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 an equivalent of $2 million also. Due to the fact that both loans are made in their distinguished currencies, both companies will be able to hedge currency risk. However, both loans will have the same maturity date, they will be paid back on the same day.
Back-to-Back Loan Risks
There are a number of risks that can be attributed to back-to-back loans. The major risk is that the two currencies in this type of loan have the tendency of being uneven in terms of loss attributable to them. This is called asymmetrical liability, except in cases where there is provision or coverage for asymmetrical liability is clearly stated in the back-to-back loan agreement. Another risk of back-to-back loan is that if one of the companies or parties defaults on loan payments, the other party is not relieved of their responsibility for repayment. Due to the inherent risks of this type of loan, the maturity date for most back-to-back loans is 10 years.