What Is Rollover Risk?
Rollover risk is a risk associated with the refinancing of debt. Rollover risk is commonly faced by countries and companies when a loan or other debt obligation (like a bond) is about to mature and needs to be converted, or rolled over, into new debt. If interest rates have risen in the meantime, they would have to refinance their debt at a higher rate and incur more interest charges in the future—or, in case of a bond issue, pay out more in interest.
- Rollover risk is also associated with the refinancing of debt—specifically, that the interest charged for a new loan will be higher than that on the old.
- Generally, the shorter-term the maturing debt, the greater the borrower's rollover risk.
- This risk can also refer to the risk that a derivatives position will lose value if and when it is rolled to a new maturity.
- Rollover risk reflects economic conditions (e.g. liquidity and credit markets) versus a borrower's financial condition.
How Rollover Risk Works
Rollover risk also exists in derivatives, where futures or options contracts must be "rolled" over to later maturities as near-term contracts expire in order to preserve one's market position. If this process will incur a cost or lose money it poses a risk.
In particular, it refers to the possibility that a hedge position will expire at a loss, necessitating a cash payment when the expiring hedge is replaced with a new one. In other words, if a trader wants to hold a futures contract until its maturity and then replace it with a new, similar contract, they run the risk of the new contract costing more than the old—paying a premium to extend the position.
Rollover Risk vs. Refinancing Risk
Also known as "roll risk," rollover risk is sometimes used interchangeably with refinancing risk. However, it's actually more of a sub-category of that. Refinancing risk is a more general term, referring to the possibility of a borrower being unable to replace an existing loan with a new one. Rollover risk deals more specifically with the adverse effect of rolling over or refinancing debt.
This effect has more to do with prevailing economic conditions—specifically, interest rate trends and the liquidity of credit—than the financial condition of the borrower. For example, if the U.S. had $1 trillion dollars of debt it needed to roll over in the next year, and interest rates suddenly rose 2% higher before the new debt was issued, it would cost the government a lot more in new interest payments.
The state of the economy is also significant. Lenders are often unwilling to renew expiring loans during a financial crisis, when collateral values drop, especially if they are short-term loans—that is, their remaining maturity is less than one year.
So along with the economy, the nature of the debt can matter, according to a 2012 article "Rollover Risk and Credit Risk," published in The Journal of Finance:
Debt maturity plays an important role in determining the firm’s rollover risk. While shorter maturity for an individual bond reduces its risk, shorter maturity for all bonds issued by a firm exacerbates its rollover risk by forcing its equity holders to quickly absorb losses incurred by its debt financing.
Example of Rollover Risk
At the beginning of October 2018, the World Bank issued concerns about two Asian nations. "Rollover risks are potentially acute for Indonesia and Thailand, given their sizable stocks of short-term debt (around $50 billion and $63 billion, respectively)," it stated.
The World Bank's concerns had reflected the fact that central banks around the world had been tightening credit and raising interest rates, following the lead of the U.S. Federal Reserve, which had increased the federal funds rate steadily between 2015 and December 2018, from near 0% to 2.25%—resulting in billions in U.S. and foreign investments being pulled from both countries.
However, in the years since, central banks around the world have been lowering interest rates—following the lead of the Fed, which in March 2020, cut the federal funds rate to a range of 0.0% to 0.25% for the second time since the 2008 financial crisis. The move was made to support the economy amid the COVID-19 pandemic. As of December 2020, the Fed said it intended to keep the fed funds rate in the same range until inflation has risen 2 percent and is on track to moderately exceed 2 percent for some time.