What is a 'back to back' business between companies?

Answer 1

"Back to Back" business can refer to an "interest swap" arrangement that some businesses and hedge funds utilize to minimize risk. To understand a "back to back" interest swap you must first understand how and why a regular interest rate swap works. Interest swaps involve two parties. One party signs the contract as a "hedge" or insurance to protect themselves from loss, and the other party is a speculator/investor hoping to capitalize if things go their way.

A plain interest swap works like this; Party A is a bank who collects interest on it's loans at a fixed rate. This bank also pays interest to it's depositors at a variable rate that goes up and down. Depending on how interest rates go the bank could come out way ahead or fall behind. So to stabilize this they utilize an interest swap contract. The bank would offer to pay an investor (party B) a fixed interest payment on a dollar amount agreed upon by the two parties. This is the point most people get confused. There is no loan to anyone here, there is only an agreement to pay an interest rate on a specific dollar amount. Party A will pay a fixed interest rate to party B. In turn party B will pay party A a "variable" interest rate; usually based on the federal funds rate or the LIBOR plus a premium. So party A is paying a known amount to party B and party B is paying an unknown amount to party A. If interest rates go up than party B is going to loose out but if interest rates go down, below whatever fixed rate they have agreed upon than he comes out ahead. Party A wins regardless really because the main motivation for party A was to be able to collect a variable interest rate, because that's what it must pay it's customers with. It has in effect simply converted the fixed interest it collects on mortgages and auto loans to a floating variable interest by transferring the risk to an investor.

This brings us to the "Back to Back" business. Using the above scenario let's say that party B isn't 100% sure interest rates will go down and cause him to reap a profit. Party B then might engage in further credit swaps to hedge his bet, thus the back to back. Party B could enter in another contract with a party C. In this case instead of being the party paying the variable interest he would offer to pay party C a fixed interest payment and receive an agreed upon variable rate. This "back to back" arrangement doesn't really concern party A or C since there is no actual loaning of money, rather just an agreement or gamble on whether interest rates will go up or down. Remember that if interest rates go down party B wins but if they go up than party B looses. By entering into a back to back arrangement, if interest rates go precipitously down than party B won't loose everything because of his arrangement with party C. Conversely, this contract will cut into party B's profits if interest rates go down; but that's the nature of insurance, to protect yourself from loosing everything. These contracts usually involve very large amounts of money and involve very small variations in interest rates; far less that 1 percent.