200 CHAPTER 5. USING FORWARDS FOR INTERNATIONAL FINANCIAL MANAGEMENT
that the pressure on thegbp(and the corresponding scarcity ofusdreserves) was
temporary, the BoE would borrowusd from, say, the Bundesbank (Buba), the
central bank of Germany. The Buba would ask for some form of security for such
a loan. In a classical short-term swap deal, the guarantee was in the form of an
equivalent amount ofgbp to be deposited with the Buba by the BoE. Barring
default, on the expiration day theusdand thegbpwould each be returned, with
interest, to the respective owners. If either party would default, the other was
automatically exonerated of its own obligations and could sue the defaulting party
for any remaining losses.
Example 5.23
The central bank of the former Soviet Union often used gold as security for hard-
currency loans obtained from western banks, but repeatedly failed to pay back the
loans. For the western counterparty, the risk was limited to the face value of the
loan minus the market value of the gold. The Soviet Union always made good this
loss.
Example 5.24
Companies often post bonds or T-bills or other tradable securities as guarantee to a
loan. One way to view this is that the borrower lends the bonds to the bank, which
in return then lends money to the company. The bank can confiscate the bonds and
sell them off if the company fails to pay back the loan.
Other applications are of the pure back-to-back loan type: a customer lends
money to the bank, which in turn lends back money to the customer and uses the
deposit as security for the loan. One motivation may be money laundering:
Example 5.25
After a long and successful career in the speak-easy business, Al-C wants to retire
and spend his hard-won wealth at leisure. Fearing questions from the tax authorities,
he deposits his money in the Jamaica office of a big bank, and then borrows back
the same amount from the NY office of that bank. The deposit serves as security
for the loan: if Al is unexpectedlytaken out, the bank confiscates the deposit in
lieu of repayment of the loan. And when questioned by the tax inspectors as to the
source of the money he spends so freely, Al can prove it is all borrowed money.^12
Another motivation is avoidance of exchange restrictions or other costs of moving
money across borders. Back-to-back loans (or parallell loans) were often inspired
by the investment dollar premium that existed in theukfrom the late sixties to
(^12) The example lacks credibility because the taxman’s next question would bewhythe bank lent
so much to Al. So this can only be done on a small scale, by persons or companies that could have
borrowed such amounts without the guaranteeing deposit.