5.5. USING FORWARD CONTRACTS (4): MINIMIZING THE IMPACT OF MARKET
IMPERFECTIONS 201
Figure 5.8:The Parallell loan – Example 1UKII USCOSubNYSE USCOGBP loanusdinvestments usdloan
96the mid-seventies and made it expensive for companies to buy dollars for foreign
investments.^13 Back-to-back loans, promoted and arranged byukmerchant banks,
were a way to avoid this investment dollar premium.
Example 5.26
Suppose aukinstitutional investor (UKII) would like to invest in theNYSE. The
trick is to find a foreign company (say,USCO) that wants to extend a loan to its
uksubsidiary. TheUSCO, rather than lending to itsuksubsidiary, lendsusdto
UKII. Thus, theUKIIborrowsusdand pays them back later, which means that it
does not have to buyusdinitially and that there is no subsequent sale ofusd. In
short, the investment dollar premium is avoided. The second leg of the contract is
thatUKIIlendsgbptoUSCO’s subsidiary, so thatUSCO’s objectives are also satisfied.
The expected gains from avoiding the implicit tax can then be divided among the
parties. The flow of the principal amounts of the reciprocal loans is shown in Figure
5.8.
As it stands, the design of the back-to-back loan would be perfect if there were
no default risk. Suppose, however, thatUSCO’s subsidiary defaults on itsgbploan
from theUKII. If no precautions had been taken,UKIIwould still have to service the
usdloan fromUSCO, even thoughUSCO’s subsidiary did not pay back its own loans.
Writing a right-of-offset clause into each of the separate loan contracts solves this
problem. IfUSCO’s subsidiary defaults, thenUKIIcan suspend its payments toUSCO,
and sue for its remaining losses (if any)—and vice versa, of course. Thus, the right
of offset in the back-to-back loan is one element that makes this contract similar
to mutually secured loans. The similarity becomes even stronger if you consolidate
(^13) In those years, theukhad a two-tier exchange rate. Commercialusd’s (for payments on
current account, like international trade and insurance fees) were available without constraints, but
financialusd’s (for investment) were rationed and auctioned off at premiums above the commercial
rate. These premiums, of course, varied over time and thus were an additional source of risk to
investors. In addition, the law said that when repatriatingusdinvestments, aukinvestor had to
sell 25 percent of his financialusdin the commercial market; the premium lost was an additional
tax on foreign investment. In summary, there was quite a cost attached to foreign investment by
ukinvestors.