CFA, Finance, FRM

What is Roll over Risk

What is Roll over Risk?

  • Short term debt instruments (bonds, commercial papers and debentures) mature on specified duration. Companies which have issued such debt in different financial instruments are supposed to refinance/roll over debt for next maturity.
  • While rolling over/extending the maturity, the firms are exposed to financial risks like facing troubles in rolling over the debt due to unfavourable credit market conditions (known as liquidity risks), refinancing debt at higher interest rates in rising interest rate scenario resulting in shelling out higher interest expenditures. Such risks are known as roll over risks.

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  • Roll over risks share significance in derivative positions. Suppose an investor holding any long/short position in futures is expected to square off the position at expiry and roll over the futures contract, the investor stands at the risk of squaring off position on unfavourable price terms requiring instant margin payments and further extracts more money for rolling over the futures due to expensive pricing.

Why do companies roll over debt?

  • Companies tend to resort to short term debt financing for funding their medium to long term projects.
  • Short term financing is generally cheaper than long term one due to more risk over a long term in upward sloping curve scenario (Interest rates tend to be upward slopping in moderately inflationary scenario assuming continuation of growth in economy).
  • Companies raising funds adopt short term financing for cheaper payments and boosting profits. Funding houses are ready to infuse funds in companies with sound balance-sheets which give high assurances for timely interest and principal payments.
  • Companies can also enjoy comfort of refinancing debt at lower interest rates (in case interest rates fall) giving them more financial cushion.

What happens when credit markets deteriorate?

  • When credit markets face turbulent times, liquidity becomes scarce. Thus, companies with unsound financial parameters face high difficulty in rolling over debt because of uncertainty to pay debts on time.
  • Finance institutions distribute funds to companies which have survived in turbulent cycles & have shown resilience in revenues (famously known as flight to safety). Such conditions pose significant roll over risks that can put companies’ future in perils. (due to financing being unavailable when in need/higher expenditure to obtain financing)

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Real-Life Example:

  • In 2018, Indian Non-Banking Finance Sector struggled with financial crisis. To put things simply, a couple of NBFC companies started defaulting on interest payments when they had issues in collection of revenues in timely fashion.
  • Defaulting on interest payments made it difficult to roll over debt because funding houses have specific regulatory criteria to bear risks which were already violated. This led to a spread of contagion leading many entities to almost potential default like situations.
  • Such roll-over risks lead to spread of financial troubles across the industry due to inter-connectedness.

Conclusion:

  • Roll over facility has been of paramount importance in financial industry. If we remain mindful of roll over risk and adjust our borrowings accordingly, it shall continue to serve its purpose for convenient refinancing.

 

Author: Ashutosh Buch

About the Author: Ashutosh Buch is CFP (FPSB India) & CFA level-2 candidate at CFA Institute.  His primary interest lies in analyzing investments in primary & secondary markets. At present, he focuses on learning nuances of financial markets & management consulting. He remains committed to his goal of helping businesses scale up & making them ESG-friendly.

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