Rollover Risk: Definition, Overview & Examples
The risk associated with rolling over a monetary debt obligation or a derivative position purchased for hedging purposes that is approaching maturity is known as rollover risk.
As a crucial component of asset-liability management, rollover risk is regularly managed by banks and other financial institutions when they rollover their liabilities. Additionally, it is a typical risk associated with derivative rollovers performed by fund managers, portfolio investors, etc.
Read on as we take a look at exactly what rollover risk is, the features of it, how it works, and the advantages and disadvantages associated with it.
Table of Contents
- Rollover risk relates to the refinancing of certain debt obligations, such as a loan or a bond. When this happens, the interest that’s charged on a new loan would be higher compared to the original loan interest amount.
- In most cases, maturing debt that is short-term will bring a higher rollover risk for the borrower.
- Rollover risk is going to reflect the current economic conditions, such as credit markets and liquidity, instead of the financial condition of a borrower.
What Is Rollover Risk?
Rollover risk relates to the risks that are associated with refinancing debt. It’s usually faced by companies that have a debt obligation, like a loan, that is going to mature. When this happens, there becomes a possibility to convert it, or in this case roll it over, into new debt.
If interest rates happen to rise, the company would need to refinance its debt at a higher rate. By doing this they’re likely going to have to pay more in interest charges down the road. In the case of a bond issue, the company would need to pay out more in interest.
Features of Rollover Risk
There is a broad range of features that can get recognized with rollover risk. Here are some of the most common to be aware of:
- If a person that holds a loan or debt obligation is finding it difficult to repay their principal amount
- When an existing debt has a repayment due in a short period
- If there are high chances that costs associated with refinancing would be higher compared to the original amount
- Whoever the obligation holder is would pose a bankruptcy risk to bankers or investors over a repayment is delayed
- When there is a successful rollover it can help the obligation holder save their liquidity position
- If there becomes a change that investors might not allow refinancing, which can lead to a cash-squeeze position
- When there is a non-conversion of existing debt that could lead from financial risk to business risk
How Rollover Risk Works
It’s first important to recognize that rollover risk is prevalent and exists in derivatives. This is when futures or options contracts need to get rolled over. It works by rolling over future maturities as near-term contracts are ready to expire, all so that market position can be preserved.
In a lot of ways, rollover risk refers to the chance that a specific hedge position could expire at a loss, meaning that a cash payment would be needed when the hedge expires. If a trader wanted to hold a futures contract all the way until its maturity and then replace it, there becomes a risk of the new contract costing more. Essentially, this means the trader would be paying a premium to extend their current position.
Let’s break down how rollover risk works even further.
When it relates to a normal debt obligation, whoever the debt holder is would explore possibilities of refinancing the debt. When this is done, there becomes a new set of terms and conditions to abide by.
New financing can be done through an existing banker or a new one, and if interest rates are reduced then the debt holder sits at a profit. This is solely due to the reduced interest obligations in the future.
With derivatives, the debt holder takes a specific position in the futures or options contract, which is also known as hedging against a position. When this happens the holder wants to have their maturity rolled over to another date in the future.
By doing this, the holder can maintain their current position in the market rather than closing the position. Carrying this forward helps reduce the possibility that the trader might see their hedge result in a loss.
But when the rollover happens, the trader would need to pay any difference in cash. However, they wouldn’t need to pay that difference at the current moment, only the premium amount.
Rollover Risk Advantages and Disadvantages
Depending on the type of debt obligation, there can be some different advantages and disadvantages to recognize rollover risk. Here are some of the biggest ones to consider:
- Debt holders can see their liquidity position improve
- If interest rates fall, you can refinance existing debt with a new debt that has a lower rate of interest
- The debt holder’s solvency position can be protected from exposure
- With derivative contracts, the existing position can get carried forward instead of simply paying the difference in a loss situation
- Floating rate liabilities can get converted into fixed-rate liabilities
- If the rollover is unsuccessful, businesses can face additional funding problems, leaving a possibility of default risk and bankruptcy
- There can be substantial costs associated with rolling over
- There becomes a risk that new interest rates are higher than the existing interest rate
- The price of a new maturity for a futures contract could be unfavorable, leaving a need to pay a higher difference
Rollover risk has to do with the risks that can come with converting, or rolling over, an existing loan or debt obligations. This usually happens when the period is about to mature, and a company or country wants to convert the old loan or debt into a new one.
This can be a critical step to take to ensure the solvency position. Existing debts are always going to be due within a short amount of time, and sometimes it can be difficult to pay debt obligations. The costs associated with refinancing can often be higher, however, a successful rollover could help the obligation holder save their liquidity position.
Frequently Asked Questions
Rollover risk in real estate can relate to the risks associated with analyzing credit requests. Identifying these risks early and determining a strategy to manage the risk level is critical to aligning with credit standards.
Rollover risk can relate to the risks associated with expiring lease agreements. This includes the potential of not being able to re-lease a property or signing a new lease with less favorable terms compared to the original lease.
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