Rollover Risk

Rollover Risk refers to the risk arising out of rollover of a financial debt obligation or a derivative position taken for hedging purposes, which is due for maturity. Rollover Risk is frequently managed by banks and financial institutions while doing a rollover of their liabilities and is an integral part of asset-liability management. It is also a common risk that usually comes across derivative rollovers undertaken by hedge funds, portfolio investors, etc.

Rollover Risk can result in a liquidity crunch for the business and have a ripple effect on the market as a whole. It is well known that many businesses, primarily banks and financial institutions, create their assets by way of advancing loans and advances by borrowing through short term sources and rollover such short term debts whenever such securities are due for redemption with fresh new securities, and this way, business goes on. In fact, the various governments in different countries also fund their borrowing this way and roll over maturing debts with new debts.

However, when a business is unable to roll over its existing debts with new debts or have to pay the higher interest rate for rollover of such debts, this can result in refinancing risk, which is a subtype of rollover risk.

In extreme cases, rollover risk can lead to complete freezing of business ( usually in such cases where there is a severe liquidity crunch and business is unable to roll over its maturing liabilities or cases where derivatives instruments used for hedging are in heavy losses and cash settlement on maturity is not possible by the business due to severe liquidity crunch).

• Rollover risk refers to the chance that a borrower may be unable to refinance or renew their existing debt obligations at favorable terms or, in some cases, may not be able to refinance at all.
• Rollover risk arises due to a maturity mismatch between a borrower's short-term debt obligations and the availability of financing to meet those obligations. If the borrower cannot secure favorable refinancing terms, it may face liquidity problems or be forced to pay higher interest rates, potentially leading to financial distress.
• Prevailing market conditions and investor sentiment influence rollover risk. During periods of financial instability, economic downturns, or a loss of confidence in a borrower's creditworthiness, investors may be reluctant to provide refinancing, exacerbating rollover risk.
• Companies and financial institutions actively manage rollover risk by monitoring their debt maturity profiles, maintaining good credit ratings, diversifying funding sources, and developing contingency plans to address potential refinancing challenges.

Let's understand rollover risk in more detail with the help of a few examples:

Example #1

Mega Bank manages its asset-liability by mapping its highly liquid assets (assets which can be converted into cash in the shortest possible time) with its expected withdrawal rate in stress scenarios. The bank usually rolls over its liabilities to generate such highly liquid assets to maintain an adequate liquidity coverage ratio of 100%.

The following information is collected for Mega Bank for December 2019 and March 2019 ( in USD Mio):

Example #2

Let's take another example to understand it further:

Commercial Bank of Atlanta’s main source of funding is deposited from its customers, which accounts for 60% of its total financing needs, and the balance financing is met by the bank through short term financing in the form of commercial papers. The bank usually keeps its funding cost in the range of 2-3 percent and lend advances in the range of 4-5 percent to ensure a steady net interest margin. Due to the short term financing dependence, the commercial bank is exposed to rollover risk.

Commercial bank of Atlanta suffered heavily during the Lehman bankruptcy as commercial borrowing declined heavily, and the bank was not able to roll over its short term financing due to the complete liquidity crunch and fragility in the bank, leading to its ultimate failure on account of inability to serve its customers.

Thus rollover risk can lead to regulatory penalties and even untimely closure of the business if not managed properly or due to adverse market conditions leading to the risk going out of control.

• Hedge positions in derivative instruments are required to be rollover on maturity, which led to rollover risk but are necessary to hedge position taken in the cash segment in capital markets.
• Various floating rate liabilities are converted by financial institutions into fixed liabilities by entering into interest rate swaps, which need to be rolled over on maturity resulting in rollover risk. However, business needs to take such risk to ensure that it can convert its liabilities fixed and manage its interest rate risk in a better way.
• Businesses can roll over their short-term borrowings at favorable rates in a falling interest rate scenario. In such cases taking rollover risk is beneficial to the business.

Some of the disadvantages are as follows.

• They lead to liquidity risk for the business and can lead to massive funding problems for the business.
• The inability of the business to roll over its matured liabilities can lead to default and can result in the bankruptcy of the business. In short, rolling risk has the potential of threatening the very existence of the business itself.
• Rolling risk increases the cost of conducting business as the cost of borrowing keeps changing based on market behavior, and investment climate and business will have to roll over its liabilities at the rate prevalent at the time of maturity of its short term liabilities irrespective of the rates which can hurt business margins.

Business needs to understand that rollover risk needs to be closely monitored and managed effectively, especially in difficult situations like liquidity crunch, etc., which can make rollover difficult and, at times, impossible for the business. If it is managed effectively, it can be an effective tool for business to enhance its returns and magnify its earnings.

This has been a guide to what is rollover risk and its definition. Here we discuss some examples of rollover risk along with advantages and disadvantages. You can learn more from the following articles –

• Downside Risk Example
• Inherent Risk Definition
• Operational Risks
• Prepayment Risk Definition