What Is Rollover Risk?

What Is Rollover Risk?

Let me explain rollover risk directly to you: it's the risk you face when refinancing debt. As a borrower—whether you're a country, a company, or an individual—you encounter this when a loan or bond is maturing and needs to be rolled over into new debt. If interest rates have gone up since you took out the original debt, you'll end up paying more in interest on the new one. This is much like reinvestment risk, where your returns might drop on new investments.

Rollover risk can also mean the chance of losing money when you roll over derivatives positions to maintain your market stance.

Key Takeaways on Rollover Risk

Here's what you need to grasp: rollover risk ties into refinancing debt where the new loan's interest is higher than the old one's. The shorter the term of the maturing debt, the bigger this risk becomes for you as the borrower. It also covers the potential value loss in derivatives when you roll them to a new maturity date. Overall, this risk mirrors broader economic conditions, such as liquidity and credit markets, rather than just your personal financial situation.

How Rollover Risk Works

You might hear rollover risk called 'roll risk,' and it's often swapped with refinancing risk, but it's actually a specific subset. Refinancing risk is broader—it's about not being able to replace an old loan at all. Rollover risk focuses on the negative impacts when you do roll over or refinance, like facing worse terms.

This stems from economic factors, especially interest rate shifts and credit liquidity, not so much from your own finances. Imagine the U.S. government has $1 trillion in debt to roll over next year, and rates jump 2% higher right before issuance—that means billions more in interest payments for taxpayers.

Special Considerations

The economy's state matters a lot here. During a financial crisis, lenders might not want to renew loans, particularly short-term ones under a year, as collateral values plummet.

Debt maturity is key too, as noted in a 2012 Journal of Finance article: while short maturity lowers risk for a single bond, having all your bonds short-term ramps up rollover risk for the firm, forcing equity holders to absorb losses fast from debt financing.

Derivatives Roll Risk

In derivatives, rollover risk hits when you need to roll futures or options to later dates as they expire, to keep your position. If this costs you money or leads to losses, that's the risk.

Specifically, if your hedge expires at a loss, you'll pay cash to replace it with a new one. For traders holding a futures contract to maturity and then swapping to a similar new one, there's a risk the new contract costs more, meaning you pay a premium to extend.

Example of Rollover Risk

Take October 2018: the World Bank warned about Indonesia and Thailand, with their short-term debt stocks around $50 billion and $63 billion respectively, facing acute rollover risks.

This came as global central banks tightened credit and hiked rates, following the U.S. Fed's increases from near 0% to 2.25% between 2015 and 2018, pulling investments out of those countries. From 2008 to 2021, rates dropped to 0-0.25% to aid the economy during COVID, but 2022's inflation forced hikes again, potentially renewing rollover risks.

How Can Rollover Risk Be Minimized?

Interest rate changes are beyond your control, so minimizing rollover risk isn't straightforward. Institutional traders can hedge with interest rate derivatives, but that's not typically an option for everyday individuals like you.

When Is It Best to Refinance a Mortgage?

If your mortgage has no prepayment penalties, refinance when rates drop—it lowers your monthly payments and total interest. But remember, refinances involve fees and closing costs, so the rate drop needs to be big enough to offset those.

What Is Roll Risk in Derivatives Trading?

In derivatives trading, contracts expire regularly, so you roll positions to longer-dated ones to maintain them. Roll risk here is the potential for losses from this rollover process.