What Is Mismatch Risk?
Mismatch risk has a number of particular definitions in finance, but with each basically referring to the chance that a loss can arise from an incompatibility between two or more parties and their objectives. Mismatch risk can often take the form of a principal-agent problem.
The principal-agent problem is a conflict in priorities between a person or group and the representative authorized to act on their behalf. An agent may act in a way that is contrary to the best interests of the principal.
Concrete examples of mismatch risk include:
- Swap contract 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.
- For investors, mismatch risk occurs when an investor chooses investments that are not suitable for their circumstance, risk tolerance, or means.
- For companies, mismatch risk arises when assets generating cash to cover liabilities do not have the same interest rates, maturity dates, and/or currencies.
- A mismatch risk is the potential for losses that stem from an incompatible or unsuitable pairing of interests, financial capacity, or market view,
- Mismatch risk can occur when a swaps dealer finds it hard to find a counterparty for a swap, an investor's investment doesn't align with their needs, or a business's cash flows don't align with liabilities.
- Mismatch risk may be alleviated by one party agreeing to slightly modify their prior expectations or goals.
Understanding Mismatch Risk
Investors or companies experience mismatch risk when transactions in which they engage or assets they hold are not aligned with their needs.
As discussed above, there are three common types of mismatch risk related to swap transactions, investor investments, and cash flows.
Mismatch Risk with Swaps
For swaps, a number of 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. 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.
Mismatch Risk for Investors
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. Or a risk-averse investor that buys an aggressive mutual fund or investments with significant volatility.
Mismatch Risk for Cash Flows
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, but the company must pay rent, utilities, and suppliers on a monthly basis. The company may be exposed to missing its payment obligations if it doesn't manage its money tightly between receiving funds.
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.
A 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 bank's 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. For example, assume a bank has $1 billion in short-term borrowings in USD, and $1 billion long-term loans overseas in different currencies. While they may have other borrowings and loans that help hedge the currency exposure, they may still be exposed to currency fluctuations which affect their profitability.
They could enter into a swap contract to help offset some of the currency fluctuations. This once again may leave them with a possible mismatch risk related to the swap transactions.