What it is:
How it works (Example):
Company XYZ is in the United States and Bank ABC is in Germany. Company XYZ is concerned about the value of the dollar changing relative to the euro.
To mitigate this concern, Company XYZ and Bank ABC structure a back-to-back loan, whereby Company XYZ deposits $1 million with Bank ABC, and Bank ABC (using the deposit as security) lends Company XYZ $1 million worth of euros. The current between American dollars and euros is 1:0.50 (that is, $1 buys half a euro). The bank and Company XYZ agree to a one-year term on the loan and a 5% interest rate. When the loan term ends, Company XYZ repays the loan at the fixed rate agreed upon at the beginning of the loan term, thereby insuring against currency risk during the term of the loan.
Why it Matters:
Companies could certainly tradein the markets, but back-to-back loans can be more convenient, and the companies get the they need. However, swaps and similar instruments have largely replaced back-to-back loans. Regardless, these instruments promote international trade.
Though our example involves two relatively stable, back-to-back loans most commonly involve unstable (due to their high volatility, thus created more need among companies in those countries to mitigate their ).