What is Mismatch Risk
Mismatch risk has several definitions that basically refer to the chance that suitable counterparties for swap contracts cannot be found, unsuitable investments have been made for certain investors or the cash flows from assets and liabilities do not align.
1) More specifically, for swap contracts, mismatch risk refers to the possibility that a swap dealer will be unable to find a suitable counterparty for a swap transaction for which it is acting as an intermediary.
2) For investors, mismatch risk occurs when an investor chooses investments that are not suitable for his or her circumstances, risk tolerances or means.
3) For companies, this arises when assets generating cash to cover liabilities do not have the same interest rates, maturity dates and/ or currencies.
BREAKING DOWN Mismatch Risk
Investors or companies experience mismatch risk when transactions in which they engage or assets they hold are not aligned with their needs.
1) For swaps, a number of different factors can make it difficult for a swap bank or another intermediary, to find a counterparty for a swap transaction. For example, one company may need to engage in a swap with a very large notional principal but finds it difficult to find a willing counterparty to take the other side of the transaction. The number of potential swappers may be limited, in this case.
Another example may be a swap with very specific terms. Again, counterparties may not have needs for those exact terms so in order to gain some of the benefits of the swap, the first company may have to accept slightly altered terms. That could leave it with an imperfect hedge or a strategy that may not match its specific forecasts.
2) For investors, a mismatch between investment type and investment horizon can be a source of mismatch risk. For example, mismatch risk would exist in a situation where an investor with a short investment horizon (such as one who is near retirement) invests heavily in speculative biotech stocks. Typically, investors with short investment horizons should focus on less speculative investments such as fixed income securities and blue-chip equities.
Another example would be an investor in a low tax bracket investing in tax-free municipal bonds.
3) For companies, a mismatch between assets and liabilities may produce cash flow that does not match with liabilities. One example might be when an asset generates semi-annual payments, as a bond might do, but the company must pay rent, utilities and suppliers on a monthly basis. The company would be exposed to missing its payment obligations.
Another example might be a company receiving income in one currency but having to pay its obligations in another currency. Currency swaps might be employed to mitigate that risk.
Classic Mismatch Example
The classic example of risks between assets and liabilities is a bank that borrows in the short-term market to lend in the long-term market. When short-term interest rates rise and long-term rates stay flat, the bank's ability to profit declines. The spread between short- and long-term rates, or the yield curve, shrinks and that squeezes the banks profit margins.
Compound that risk for a global bank with currency mismatches and the need for an exotic, hard to accomplish, swap transaction to mitigate those risks and the bank has a triple mismatch.