What is 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 rollover 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 government 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 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. 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. 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:
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. (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):
The bank is expected to keep its liquidity coverage ratio above 100% at all times, and failure to do so attracts a regulatory penalty. In March 2019, Banks Liquidity Coverage Ratio fell below 100%, and due to a severe liquidity crunch in the market, the bank was not able to roll over its short-term liabilities resulting in regulatory LCR falling below the threshold level leading to a penalty for the bank.
Through the above example, we try to highlight how rollover risk can lead to regulatory penalties.
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.. 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. 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..
- Various floating rate liabilities are converted by financial institutions into fixed liabilities by entering into interest rate swaps, which need to be rollover 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. 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. 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 –