Parallel Loan - Explained
What is a Parallel Loan?
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Table of ContentsWhat is a Parallel Loan?How Does a Parallel Loan Work?Example of How a Parallel Loan WorksPros and Cons of a Parallel LoanSpecial Considerations for a Parallel Loan
What is a Parallel Loan?
A parallel loan is a type of loan in which two affiliate or parent companies in different countries borrow money in their local currencies, then lend the money to each other to reduce foreign exchange risk. A parallel loan is a mutual benefit agreement between the two companies involved, there are four parties involved in this loan, the two companies, and the two local lenders. A parallel loan was an early currency swap which is now referred to as a back-to-back loan. Through a parallel loan, two parent companies domiciled in different countries can hedge against currency risk. In this type of loan, the specific time that the companies will borrow each others currencies and the maturity time for the loan is clearly stated.
How Does a Parallel Loan Work?
The central goal of a parallel loan is to hedge against currency risk between two companies in two different countries. When a parallel loan agreement is reached between two companies, the loan is repaid at a specified future date and at a predetermined exchange rate. Also, borrowing money across country lines attract certain fees and restrictions in some cases, parallel loans help companies avoid such hurdle. Parallel loan agreements eliminate the need for an exchange of one currency to the other, thereby removing the risk of exchange rate or fluctuations of currencies. The first parallel loan was executed in the United Kingdom in the 1970s.
Example of How a Parallel Loan Works
Here is an example of how a parallel loan works: Company ABC is an Indian-owned company that has a subsidiary in the United States and this subsidiary needs about 5 million US dollars to finance its operations. Company ABC has the option of sending the money to the subsidiary in rupees, but given the exchange rate risk, Company ABC approaches Company XYZ, a United States-based company to loan the subsidiary 5 million Us dollars. Company XYZ also has a subsidiary in India and agrees to offer the loan only if Company ABC will pay back the loan to Company XYZs subsidiary in India at a predetermined date.
Pros and Cons of a Parallel Loan
The major advantage of a parallel loan is that it reduces currency or exchange rate risk that companies might be exposed to when engaged in borrowing across countries. Also, when companies enter a parallel loan agreement, it is a mutually beneficial agreement that reduces borrowing costs and interest rates for both companies. The downside of the parallel loan is that it is quite difficult for companies in need of borrowing to find counterparts who also need borrowing in the respective currency. The inability to find matching orders or counterparties poses as the major con of the parallel loan. Also, when companies find matching partners is some cases, the terms and conditions of the two companies might be in conflict.
Special Considerations for a Parallel Loan
Companies can leverage other means of acquiring loans that will hedge against currency exchange risk outside of the parallel loan. Trading in the currency markets is another option companies can explore to access funding in the desired currency, they can either trade in cash or futures. Furthermore, with the emergence of foreign exchange trading (forex trading) platforms, parallel loans have lost their prominence, with exception to cases when two parent companies reach an agreement to trade directly.