What is Rollover Risk?
Rollover risk refers to the uncertainty faced by countries and companies when they need to refinance debt that is maturing. This involves the risk that new loans or bonds will carry higher interest rates than the old ones, resulting in increased interest charges. The concern is similar to reinvestment risk.
Rollover risk also applies in the world of derivatives, describing the possibility of financial loss when derivatives positions are rolled over to new maturities.
Key Takeaways
- Higher Refinancing Rates: Rollover risk is largely about facing higher interest rates when refinancing debt.
- Term Maturity Influence: Generally, shorter-term debts entail greater rollover risk.
- Derivatives Implications: This risk pertains to potential financial loss when renewing derivatives contracts.
- Economic Impact: Economic conditions like liquidity and credit markets greatly affect rollover risk, often more so than the financial health of the borrower.
How Rollover Risk Works
Commonly referred to as “roll risk,” rollover risk is specifically a subset of refinancing risk. While refinancing risk is the broader fear of being unable to replace old loans with new ones, rollover risk zeroes in on the detrimental effect of refinancing under adverse economic conditions.
For instance, if a country needs to roll over $1 trillion of debt and interest rates rise by 2%, it stands to incur significantly higher interest costs.
Special Considerations
Beyond economic conditions, the nature and term of the debt can also influence rollover risk, particularly during financial crises. Lenders may be reluctant to renew short-term loans due to devalued collateral.
According to the article Rollover Risk and Credit Risk from The Journal of Finance, debt maturity substantially impacts a firm’s rollover risk. Shorter maturities for a firm’s collective bonds increase rollover risk significantly.
Derivatives Roll Risk
In the derivatives market, rollover risk involves futures or options contracts that must be extended as they near expiration. Failure to do so without incurring losses constitutes roll risk.
Specifically, this risk involves losing money or paying a premium to replace an expiring contract with a new one in hedging strategies.
Example of Rollover Risk
In October 2018, the World Bank highlighted rollover risk concerns for Indonesia and Thailand due to their substantial short-term debt. With global central banks raising interest rates, billions were withdrawn from those countries, emphasizing the impact of economic policies on rollover risk.
Between 2008 and 2021, a lower federal funds rate of 0.0% to 0.25% mitigated rollover risk, but policy shifts in 2022 necessitated by rising inflation renewed these concerns as interest rates climbed again.
How Can Rollover Risk Be Minimized?
Mitigating rollover risk largely depends on anticipating interest rate trends. Institutional traders can use derivatives to hedge this exposure, though these tools are less accessible to the individual investor.
When Should You Refinance a Mortgage?
For homeowners, refinancing a mortgage when interest rates drop may reduce monthly payments and overall interest expenses. Any decision to refinance should account for associated costs to ensure net savings.
What is Roll Risk in Derivatives Trading?
In derivatives trading, positions need to be “rolled over” as contracts expire to maintain them. Roll risk describes the potential financial loss or added costs associated with transitioning to new contracts.
Related Terms: debt refinancing, reinvestment risk, liquidity risk, interest rate risk.
References
- Princeton University. “The Journal of Finance: Rollover Risk and Credit Risk”, Page 392.
- ISSUU. “World Bank East Asia and Pacific Economic Update October 2018”, Page 43.
- ISSUU. “World Bank East Asia and Pacific Economic Update October 2018”, Pages 19,42.
- Federal Reserve Board. “Federal Reserve Issues March FOMC Statement”.
- Federal Reserve Board. “Federal Reserve Issues December FOMC Statement”.
