What is the risk of mismatch?
Mismatch risk has a number of particular financial definitions, but each basically refers to the possibility that a loss may arise from an incompatibility between two or more parties and their objectives. The risk of mismatch can often take the form of a principal-agent problem.
The principal-agent problem is a conflict of priorities between a person or group and the representative authorized to act on their behalf. An agent may act contrary to the best interests of the principal.
Specific examples of mismatch risk include:
- Swap contract mismatch risk refers to the possibility that a swap trader may not be able to find a suitable counterparty for a swap transaction for which it acts as an intermediary.
- For investors, mismatch risk occurs when an investor chooses investments that are not suitable for their circumstances, risk tolerance, or means.
- For companies, the risk of mismatch arises when assets that generate cash to cover liabilities do not have the same interest rates, maturity dates and / or currencies.
- A mismatch risk is the potential for losses arising from an incompatible or inappropriate combination of interests, financial capacity, or market vision.
- Mismatch risk can occur when a swap dealer has difficulty finding a counterparty for a swap, an investor’s investment does not align with its needs, or a company’s cash flows do not align with liabilities.
- The risk of mismatch can be alleviated if one of the parties agrees to slightly modify its previous expectations or objectives.
Understanding the risk of discrepancy
Investors or companies experience a mismatch risk when the transactions they participate in or the assets they own are not aligned with their needs.
As mentioned above, there are three common types of mismatch risk related to swap transactions, investor investments, and cash flows.
Risk of mismatch with swaps
In the case of swaps, several factors can make it difficult for a swap bank or other intermediary to find a counterparty for a swap transaction. For example, a company may need to enter into a swap with a very large notional principal, but it is difficult to find a counterparty willing to take the other side of the transaction. In this case, the number of potential exchangers may be limited.
Another example might be an exchange with very specific terms. Again, counterparties may not need those exact terms. To get some of the benefits of the trade-in, the first company may have to agree to slightly modified terms. That could leave you with imperfect hedging or a strategy that may not match your specific forecasts.
Mismatch risk for investors
For investors, a mismatch between investment type and investment horizon can be a source of mismatch risk. For example, the risk of mismatch would exist in a situation where an investor with a short investment horizon (such as one that is close to retirement) invests heavily in speculative biotech stocks. Typically, investors with short investment horizons should focus on less speculative investments such as fixed income securities and top-tier stocks.
Another example would be an investor in a low tax bracket investing in municipal bonds tax-free. Or a risk-averse investor who buys an aggressive mutual fund or investments with significant volatility.
Mismatch risk for cash flows
For businesses, a mismatch between assets and liabilities can produce cash flow that does not match liabilities. An example might be when an asset generates semi-annual payments, but the business must pay rent, utilities, and vendors on a monthly basis. The company can be exposed to default on its payment obligations if it does not manage its money strictly between receiving funds.
Another example could be a business that receives income in one currency but has to pay its obligations in another currency. Currency swaps could be used to mitigate that risk.
A classic example of mismatch
The classic example of risk between assets and liabilities is a bank that borrows in the short-term market to lend in the long-term market. When short-term interest rates increase and long-term rates remain stable, the bank’s ability to make a profit decreases. The spread between short and long-term rates, or the yield curve, contracts and that squeezes the bank’s profit margins.
Add in that risk for a global bank with currency mismatches and the need for an exotic and difficult swap transaction to mitigate those risks, the bank has a triple mismatch. For example, suppose a bank has $ 1 billion in short-term loans in USD and $ 1 billion in long-term loans abroad in different currencies. While they may have other loans and loans that help hedge their currency exposure, they may still be exposed to currency fluctuations that affect their profitability. They could enter into an exchange contract to help offset some of the currency fluctuations. Again, this can leave them with a potential mismatch risk related to swap transactions.