Parallel loan

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A parallel loan is two loans taken out by two pairs of companies in different countries from local lenders with the aim of swapping the resulting loans in different currencies. It was an early form of currency swap.

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In a parallel loan there is an exchange of currencies between four parties which promises that the loan will be repaid at a specified future date and predetermined exchange rate. [1] [ page needed ] It consists of two pairs of the affiliated companies and two pairs parents companies in two different countries. [1] [ page needed ] It occurs between two companies simultaneously when a company has a relative advantage in the cost of funds and then borrows those funds to a foreign affiliate in its own country at a rate lower than the foreign affiliate would have to pay at its parent company's country. [2] [ page needed ] Besides that, the parallel loan is “similar to cross-border loan, but there are no currencies in the foreign exchange markets”. [3] [ page needed ]

The parallel loan is very similar to a back-to-back loan. The parallel loan was one of the proactive management of operating exposure that offsetting expected foreign exchange exposure. Two business companies in different countries will borrow currency to each other for a particular period of time and they will return the borrowed currencies on the date they agreed to with the same loaned amount. The two loans will be valued at the prevailing spot rate and the prescribed period. The currencies borrowing activities conducted outside the foreign exchange market to avoid foreign exchange risk and legal limitations.

History

The parallel loan was established in the early 1970s in effect of the exchange controls in the United Kingdom on British companies. [4] [ page needed ] The implementation of exchange control has caused many British firms withdrawn their decision to extend their business because investing in foreign market is not attractive. After the abolition of foreign exchange control in 1979, parallel loan kept on being utilized with the goal of hedging long-term foreign currency exposure at a lower cost than what will be imposed in the foreign exchange market. [4] [ page needed ] At that time, UK organizations needed to pay a premium to get a loan in US dollars. In order to prevent this situation, UK organizations set up parallel or back-to-back loan agreement with US organizations that wish to acquire sterling. [5] [ page needed ]

The parallel loan market was created to avoid confinements imposed by the Bank of England on the free stream of British pounds. Most of the British companies who are desire to invest abroad need to change pounds into US dollars at an exchange rate over the market exchange rate. The motivation behind this strategy was to safeguard the value of the pound among other currencies. However, companies actually were not keen on providing financial aid to the Bank of England by committing the above-market rate for every dollar obtained from the exchange rate implemented in the policy. Prevention for these currency control leads straightforwardly to the improvement of the market for the currency swaps. [6] [ page needed ]

Initiated as a way of avoiding currency regulations, the practice had, by the mid-1990s, largely been replaced by currency swaps. [7]

Advantages and disadvantages

The parallel loan not only evolved to circumvent exchange control regulations, but it also permits companies to borrow funds in foreign currencies at rates lower than they might get in foreign exchange market, as overseas companies. In this situation, the parallel loan brings a few advantages and disadvantages to the companies.

Advantages

  1. Cost of the fund is fixed: The transfer of funds is less costly for both companies compared to the cost of financing from its parent company and loans from banks. In addition, the subsidiary in the country may face the problem of higher lending cost from banks if the subsidiary is not well known and its credit rating may not as high as its parent company. [8] [ page needed ]
  2. Protection against exchange rate risk: There is no foreign exchange exposure since it uses local currency where the subsidiaries are located and there is no need to enter the foreign exchange market to repay the loans.

Disadvantages

  1. Hard to find counterparties with the matching needs: Company may face the problem of finding its counterparty with the mirror image financing needs with another company such as the currencies, principals, type of interest payments, frequency of the interest payments and length of the loan period.
  2. Obligated to comply with an agreement even opposite party fails to fulfill the obligation: In order to prevent this situation happen, a separate agreement is registered to offset the party who being defaulted by another party. [1] [ page needed ]
  3. Large fees imposed on matching two companies: There is a need to hire a brokerage or investment banker to arrange this type of transactions and the companies who hire need to paid an amount of fees to the brokerage houses. [9] [ page needed ]

Related Research Articles

In economics and finance, arbitrage is the practice of taking advantage of a difference in prices in two or more markets; striking a combination of matching deals to capitalize on the difference, the profit being the difference between the market prices at which the unit is traded. When used by academics, an arbitrage is a transaction that involves no negative cash flow at any probabilistic or temporal state and a positive cash flow in at least one state; in simple terms, it is the possibility of a risk-free profit after transaction costs. For example, an arbitrage opportunity is present when there is the possibility to instantaneously buy something for a low price and sell it for a higher price.

Derivative (finance) Financial instrument

In finance, a derivative is a contract that derives its value from the performance of an underlying entity. This underlying entity can be an asset, index, or interest rate, and is often simply called the "underlying". Derivatives can be used for a number of purposes, including insuring against price movements (hedging), increasing exposure to price movements for speculation, or getting access to otherwise hard-to-trade assets or markets. Some of the more common derivatives include forwards, futures, options, swaps, and variations of these such as synthetic collateralized debt obligations and credit default swaps. Most derivatives are traded over-the-counter (off-exchange) or on an exchange such as the Chicago Mercantile Exchange, while most insurance contracts have developed into a separate industry. In the United States, after the financial crisis of 2007–2009, there has been increased pressure to move derivatives to trade on exchanges.

Financial market Generic term for all markets in which trading takes place with capital

A financial market is a market in which people trade financial securities and derivatives at low transaction costs. Some of the securities include stocks and bonds, raw materials and precious metals, which are known in the financial markets as commodities.

In finance, an interest rate swap (IRS) is an interest rate derivative (IRD). It involves exchange of interest rates between two parties. In particular it is a "linear" IRD and one of the most liquid, benchmark products. It has associations with forward rate agreements (FRAs), and with zero coupon swaps (ZCSs).

Money market Type of financial market providing short-term funds

The money market is a component of the economy which provides short-term funds. The money market deals in short-term loans, generally for a period of a year or less.

Credit derivative Exotic financial option

In finance, a credit derivative refers to any one of "various instruments and techniques designed to separate and then transfer the credit risk" or the risk of an event of default of a corporate or sovereign borrower, transferring it to an entity other than the lender or debtholder.

Hedge (finance) An investment position intended to offset potential losses or gains that may be incurred by a companion investment

A hedge is an investment position intended to offset potential losses or gains that may be incurred by a companion investment. A hedge can be constructed from many types of financial instruments, including stocks, exchange-traded funds, insurance, forward contracts, swaps, options, gambles, many types of over-the-counter and derivative products, and futures contracts.

A credit risk is risk of default on a debt that may arise from a borrower failing to make required payments. In the first resort, the risk is that of the lender and includes lost principal and interest, disruption to cash flows, and increased collection costs. The loss may be complete or partial. In an efficient market, higher levels of credit risk will be associated with higher borrowing costs. Because of this, measures of borrowing costs such as yield spreads can be used to infer credit risk levels based on assessments by market participants.

Swap (finance) Exchange of derivatives or other financial instruments

A swap, in finance, is an agreement between two counterparties to exchange financial instruments or cashflows or payments for a certain time. The instruments can be almost anything but most swaps involve cash based on a notional principal amount.

The foreign exchange market is a global decentralized or over-the-counter (OTC) market for the trading of currencies. This market determines foreign exchange rates for every currency. It includes all aspects of buying, selling and exchanging currencies at current or determined prices. In terms of trading volume, it is by far the largest market in the world, followed by the credit market.

Over-the-counter (finance) Trading done directly between two parties

Over-the-counter (OTC) or off-exchange trading is done directly between two parties, without the supervision of an exchange. It is contrasted with exchange trading, which occurs via exchanges. A stock exchange has the benefit of facilitating liquidity, providing transparency, and maintaining the current market price. In an OTC trade, the price is not necessarily publicly disclosed.

Total return swap

Total return swap, or TRS, or total rate of return swap, or TRORS, or Cash Settled Equity Swap is a financial contract that transfers both the credit risk and market risk of an underlying asset.

Liquidity risk is a financial risk that for a certain period of time a given financial asset, security or commodity cannot be traded quickly enough in the market without impacting the market price.

In finance, a non-deliverable forward (NDF) is an outright forward or futures contract in which counterparties settle the difference between the contracted NDF price or rate and the prevailing spot price or rate on an agreed notional amount. It is used in various markets such as foreign exchange and commodities. NDFs are also known as forward contracts for differences (FCD). NDFs are prevalent in some countries where forward FX trading has been banned by the government.

In finance, a currency swap is an interest rate derivative (IRD). In particular it is a linear IRD, and one of the most liquid benchmark products spanning multiple currencies simultaneously. It has pricing associations with interest rate swaps (IRSs), foreign exchange (FX) rates, and FX swaps (FXSs).

Financial risk Any of various types of risk associated with financing

Financial risk is any of various types of risk associated with financing, including financial transactions that include company loans in risk of default. Often it is understood to include only downside risk, meaning the potential for financial loss and uncertainty about its extent.

Foreign exchange risk is a financial risk that exists when a financial transaction is denominated in a currency other than the domestic currency of the company. The exchange risk arises when there is a risk of an unfavourable change in exchange rate between the domestic currency and the denominated currency before the date when the transaction is completed.

Asset and liability management is the practice of managing financial risks that arise due to mismatches between the assets and liabilities as part of an investment strategy in financial accounting.

Collateral has been used for hundreds of years to provide security against the possibility of payment default by the opposing party in a trade. Collateral management began in the 1980s, with Bankers Trust and Salomon Brothers taking collateral against credit exposure. There were no legal standards, and most calculations were performed manually on spreadsheets. Collateralisation of derivatives exposures became widespread in the early 1990s. Standardisation began in 1994 via the first ISDA documentation.

A foreign exchange derivative is a financial derivative whose payoff depends on the foreign exchange rates of two currencies. These instruments are commonly used for currency speculation and arbitrage or for hedging foreign exchange risk.

References

  1. 1 2 3 Kim, Kenneth A.; Kim, Suk H. (2015). Global Corporate Finance: A Focused Approach. World Scientific Publishing Co Inc. ISBN   9789814618021.
  2. ↑ Siddaiah, Thummuluri (2010). International Financial Management. Pearson Education India. ISBN   9788131717202.
  3. ↑ Sharan, Vyuptakesh (2012). International Financial Management. PHI Learning Pvt. Ltd.
  4. 1 2 Moosa, Imad A. (2009). International finance : an analytical approach (3rd ed.). North Ryde, N.S.W.: McGraw-Hill Australia. ISBN   9780070278516.
  5. ↑ O'Malley, Chris (2015). Bonds without Borders: A History of the Eurobond Market. John Wiley & Sons. ISBN   9781118843888.
  6. ↑ W. Kolb, Robert (2010). Financial derivatives : pricing and risk management (New ed.). Hoboken, N.J.: John Wiley & Sons. ISBN   9780470499108.
  7. ↑ Peter Moles, Nicholas Terry (1997). The handbook of international financial terms. Oxford University Press. p. 32. ISBN   978-0-19-828885-5.
  8. ↑ Homaifar, Ghassem A. (2004). Managing global financial and foreign exchange rate risk. Hoboken, N.J.: J. Wiley. ISBN   9780471281153.
  9. ↑ Murray, Tracy (1988). Handbook of international management. New York: Wiley. ISBN   9780471606741.
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