What is Rollover Risk?

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 riskRefinancing RiskRefinancing risk refers to the risk arising out of the inability of the individual or an organization to refinance its existing debt due to redemption with new debt. It carries the risk of a company failing to meet its debt obligations and is thus, also known as rollover risk.read more, 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 instrumentsDerivatives InstrumentsDerivatives in finance are financial instruments that derive their value from the value of the underlying asset. The underlying asset can be bonds, stocks, currency, commodities, etc. The four types of derivatives are - Option contracts, Future derivatives contracts, Swaps, Forward derivative contracts. read more used for hedging are in heavy losses and cash settlement on maturityCash Settlement On MaturityCash settlement is a settlement option frequently used in trading futures and options contracts, where the underlying assets are not physically delivered at the expiration date. At the same time, only the difference is paid by either of the parties, depending on the market rate.read more is not possible by the business due to severe liquidity crunch).

Examples of Rollover Risk

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 assetsHighly Liquid AssetsLiquid Assets are the business assets that can be converted into cash within a short period, such as cash, marketable securities, and money market instruments. They are recorded on the asset side of the company’s balance sheet.read more (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 ratioCoverage RatioThe coverage ratio indicates the company’s ability to meet all of its obligations, including debt, leasing payments, and dividends, over any specified period. A higher coverage ratio indicates that the business is a stronger position to repay its debt. Popular coverage ratios include debt, interest, asset, and cash coverage.read more 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 marginNet Interest MarginNet Interest Margin is a popular profitability ratio used by banks which helps them determine the success of firms in investing in comparison to the expenses on the same investments. It is calculated as Investment income minus interest expenses (this step is referred to as netting) divided by the average earning assets.read more. Due to the short term financingShort Term FinancingShort-term financing refers to financing a business for less than a year in order to generate cash for working and operating expenses, usually for a smaller amount. It include obtaining funds through online loans, credit lines, and invoice financing.read more 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.

Advantages of Rollover Risk

  • 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 marketsCapital MarketsA capital market is a place where buyers and sellers interact and trade financial securities such as debentures, stocks, debt instruments, bonds, and derivative instruments such as futures, options, swaps, and exchange-traded funds (ETFs). There are two kinds of markets: primary markets and secondary markets.read more.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 riskInterest Rate RiskThe risk of an asset’s value changing due to interest rate volatility is known as interest rate risk. It either makes the security non-competitive or makes it more valuable. read more 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.

Disadvantages of Rollover Risk

Some of the disadvantages are as follows.

  • They lead to liquidity riskLiquidity RiskLiquidity risk refers to ‘Cash Crunch’ for a temporary or short-term period and such situations are generally detrimental to any business or profit-making organization. Consequently, the business house ends up with negative working capital in most of the cases.read more 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.

Conclusion

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 ExampleInherent Risk DefinitionOperational RisksPrepayment Risk Definition