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.
In derivatives trading, rollover risk has a related but slightly different meaning. 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, he runs the risk of the new contract costing more than the old – of paying a premium to extend his position, in other words.
Rollover Risk Explained
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 syndrome. 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 United States 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. "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," according to a 2012 article "Rollover Risk and Credit Risk," published in The Journal of Finance.
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 said. The World Bank's concerns reflected the fact that central banks around the world have been tightening credit and raising interest rates – following the lead of the U.S. Federal Reserve, which has increased the federal funds rate steadily since 2015, from near 0% to 2.25% in December 2018 – resulting in billions in U.S. and foreign investments being pulled from both countries.
- Rollover risk is a risk associated with the refinancing of debt – specifically, that the interest charged for a new loan will be higher than that on the old.
- Rollover risk reflects economic conditions and interest-rate trends, and how much liquidity there is in the credit markets.
- Generally, the shorter-term the maturing debt is, the greater the borrower's rollover risk.