Updated July 14, 2023
Definition of Rollover Risk
Rollover risk means the risk associated with the rolling over (i.e., converting) of the existing loan or debt obligation of a company or a country whose period is about to mature and such conversion into a new loan or debt (with new interest rate risk) is essential for ensuring the solvency position of the company or country.
Explanation
- Risk means volatility, i.e., a movement that can be in favor or against the risk holder. A rollover means to convert. Rollover risk refers to the risk associated with such conversion. So basically, rollover is a refinancing of debt.
- There are two types of risks: business risk and financial risk. Business risk refers to the inability to run the business due to a lack of demand, etc. Financial risk refers to the inability to honor the debt repayment on time. Rollover risk is a type of financial risk.
- Let’s take an example from a layman’s perspective. Suppose a person has taken a business loan of $ 450,000 having an interest rate of 8% with a maturity period ending by December 31, 2025. Suppose by the end of the year 2024, the person understands that the cashflows in his business are reducing. If the situation remains the same by next year, he will not be in a position to honor the debt payment.
- So, he approached the banker asking for a rolling over of the debt obligation. Here, the business person has risk in case the interest rate is increased beyond the earlier rate of 8%. He has to honor the maturity amount if he does not agree with the increased interest rate.
- So, rollover risk here is an increase in the interest rate or inability of the business person to honor the debt repayment on time. Such risk can affect the credibility of the business person.
- Rollover risk is a term that can also be used in derivative contracts, such as futures and options, which need to be rolled over to a later term.
Features of Rollover Risk
The following features can characterize rollover risk:
- An existing debt has its repayment due within a short period of time.
- The person holding the loan or debt obligation finds it difficult to repay the principal amount.
- In case such repayment is delayed, the obligation holder presents bankruptcy risk to the banker or investors.
- There is high chance that the cost associated with such refinancing would be higher.
- There is a chance that lenders or investors may not allow such refinancing and which may lead the obligation holder to face a cash-squeeze position.
- Non-conversion of existing debt may lead to conversion to financial risk (i.e., repayment of loan) to business risk (i.e., inability to run the business with lack of cashflows).
- A successful rollover may help the obligation holder to save his liquidity position.
How Does It Work?
- Basically, rollover risk exists in loans as well as in derivatives.
- When it comes to normal debt obligation, the debt holder approaches the banker to consider refinancing of the debt. Such refinancing is done with new terms and conditions. The banker may be an existing banker who had provided the loan earlier or a new banker. If the interest rates have been reduced, the debt holder will profit from reduced interest obligations in the future.
- When it comes to derivatives, the holder has taken a position in the futures or options contract (i.e., hedge against a position) whose maturity is to be rolled over to a later date. This helps the holder to maintain his position in the market. So instead of closing the position, he prefers to carry forward his exposure. Such carry forward is helpful for a trader when the hedge may result in loss. As such, he would have to pay the difference in cash. He is saved from paying the cash difference now. However, such rollover requires him to pay the premium amount.
Example of Rollover Risk
Say a company has provided the following information:
| Present Date | 31-Dec-20 |
| Amount of debt due | $5,60,000 |
| Original Period (months) | 60 |
| Maturity Date | 30-Jun-21 |
| Existing EMI | 11,382 |
| Contracted interest rate | 8.10% |
| One-time cost of Rollover (i.e., commission) | 2,800 |
| Prevailing interest rate | |
| Case 1 | 7.45% |
| Case 2 | 8.95% |
| Cash flows as on date | $45,600 |
| Expected business cashflows in the next 6 months | $3,50,000 |
| Market of assets in hand | $4,20,000 |
| Cash flows as on date | $45,600 |
| Expected business cashflows in the next 6 months | $3,50,000 |
| Total Cash flows | $3,95,600 |
| Principal repayment obligation | $5,60,000 |
| Shortfall | $-1,64,400 |
Solution:
| Cash flows as on date | $45,600 |
| Expected business cashflows in the next 6 months | $3,50,000 |
| Total Cash flows | $3,95,600 |
| Principal repayment obligation | $5,60,000 |
| Shortfall | $-1,64,400 |
It can be observed that the debt holder will face a cash shortfall, and he may need to sell off his assets to honor the debt repayment. He approaches the banker for refinancing purposes. The debt holder wants to have a longer period of 6 years.
Case 1: Reduced Interest Rate
| Amount of Debt | $5,60,000 |
| New Period (months) | 72 |
| New Interest rate | 7.45% |
| Proposed EMI Amount (using PMT formula) | $9,669 |
| Existing EMI Amount | $11,382 |
| Savings in cash flows per month | $1,713 |
| Total EMIs | $6,96,162 |
| Excess amount over Principal | $1,36,162 |
Case 1: Reduced Interest Rate
| Amount of Debt | $5,60,000 |
| New Period (months) | 72 |
| New Interest rate | 8.95% |
| Proposed EMI Amount (using PMT formula) | $10,080 |
| Existing EMI Amount | $11,382 |
| Savings in cash flows per month | $1,301 |
| Total EMIs | $7,25,790 |
| Excess amount over Principal | $1,65,790 |
Explanation
- In case 1, the reduction in interest rate risk has led to savings of $ 1713 per month. The excess amount over the principal reflects the interest portion of EMIs (ignoring the present value terms).
- In case 2, the new EMI amount is lower than the existing EMI amount due to a longer period of the loan (i.e., 6 years instead of the existing 5 years). In case 2, the excess amount over the principal has increased by $ 29628 ($ 136162 – $ 165790). So, prima facie, it seems that an increase in interest rate has reduced the EMI amount. However, you can observe the total cash outflows have increased, representing an increased interest rate.
Rollover Risk Futures
- Rolling a futures contract means extending the maturity period or expiration date to a later date. This involves closing the initial contract and then taking a new position with a longer term for the same asset underlying the futures contract. Such a new position is taken at the new market price available.
- This helps the trader to maintain his risk position. Traders usually prefer to roll over in a situation wherein the existing contract may have to settle at a loss.
- The settlement of the futures contract can be done by physical settlement or cash settlement. The position is to be closed before the “first notice day” in the case of physical settlement. In case of a cash settlement, the position is to be closed before the “last trading day”.
Advantages
Some of the advantages are given below:
- In the case of economic slowdowns (like in the COVID period), the interest rates are falling. Even if the maturity is way ahead, debt holders prefer to refinance their existing debt with new debt at a reduced rate of interest. Such rollover helps the debt holder reduce the loan period and the monthly EMIs.
- The liquidity position of the debt holder is improved, and he can then focus on his business.
- The solvency position of the debt holder is saved from exposure.
- The debt holder’s credibility is maintained and saved from entering into the credit risk category due to delay in repayment of principal.
- In the case of derivative contracts, the rollover helps to carry forward the existing position instead of paying the difference (loss situation).
- This method of deferment of debt obligation can also be used to convert floating-rate liabilities into fixed-rate liabilities. Floating rate liability means LIBOR + a fixed percentage, wherein LIBOR is a floating rate. Fixed-rate liability means the fixed percentage of the interest rate.
Disadvantages
Some of the disadvantages are given below:
- The business may face a funding problem in case of rollover is unsuccessful. The business owner may have to tag himself with “default risk,” which leads to bankruptcy.
- Thus, an unsuccessful rollover can convert financial risk to business risk, which may question the business’s very existence.
- The business has to incur a substantial cost for such rollover.
- There is a risk that the new interest rate is more than the existing interest rate. This may lead to the debt holder paying a higher amount of EMIs.
- In the case of the futures contract, it may happen that the price at new maturity is unfavorable to the contract holder, and he may have to pay a higher difference.
Conclusion
Rollover risk is helpful in a situation of liquidity crunch. Such situations may make the rollover very risky for businesses. Risk can be either in terms of increased interest rate or liability of the debt holder to pay off the obligation by selling the assets. Thus, rollover risk needs to be managed effectively to ensure no credit crunch for the business. If managed appropriately, it can provide positive returns to a company, which can increase the shareholders’ wealth.
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