Financial swaps are usually regarded as an outgrowth of parallel and back-to-back loans. These work similarly except in one respect; parallel loans involve four firms, while back-to-back loans involve only two firms. These two instruments attained prominence in the 1970s, when the British government imposed taxes on foreign-currency transactions to prevent capital outflows. The parallel loan became a widely accepted vehicle by which these taxes could be avoided. The back-to-back loan was a simple modification of the parallel loan, and the currency swap was a natural extension of the back-to-back loan.
Parallel loans A loan that involves an exchange of currencies between four parties, with a promise to re-exchange the currencies at a predetermined exchange rate on a specified future date, is referred to as a parallel loan. Typically, though not always, the parties consist of two pairs of affiliated companies. Parallel loans are commonly arranged by two multinational parent companies in two different countries.
The structure of a typical parallel loan is illustrated in figure 7.1. Assume that: (1) a parent corporation (IBM) in the United States with a subsidiary in Australia wants to obtain a 1-year Australian dollar loan and (2) a parent corporation (WMC: Western Mining Company) in Australia with a subsidiary in the USA wishes to obtain a 1-year US dollar loan. In other words, each parent wants to lend to its subsidiary in the subsidiary's currency. These loans can be arranged without using the foreign-exchange market. IBM lends the agreed amount in US dollars
Figure 7.1 The structure of a parallel loan
Direct loan in Australian dollars dng
Figure 7.1 The structure of a parallel loan to the American subsidiary of WMC. In return for this loan, WMC lends the same amount of money in Australian dollars to the Australian subsidiary of IBM. Parallel loan agreements involve the same loan amount and the same loan maturity. Of course, each loan is repaid in the subsidiary's currency. The parallel loan arrangement avoids foreign-exchange risk because each loan is made and repaid in one currency.
Back-to-back loans A loan that involves an exchange of currencies between two parties, with a promise to re-exchange the currencies at a specified exchange rate on a specified future date, is referred to as a back-to-back loan and it involves two companies domiciled in two different countries. For example, AT&T agrees to borrow funds in the USA and then to lend those borrowed funds to Toyota in Japan, which, in return, borrows funds in Japan and then lends those funds to AT&T in the USA. By this simple arrangement, each firm has access to the capital markets in the foreign country without any actual cross-border flows of capital. Consequently, both companies avoid exchange rate risk in a back-to-back loan.
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