Why are there mismatch risks in swaps, investors, and cash flows?
Understanding mismatch risks
If you say the term "mismatch risk," you might get a different answer from one person to another. In finance, it might mean many things, but it will all go down to the possibility that there was a loss because two or more entities and their objective are not compatible. Hence, we call it mismatch risk. Usually, it takes the form of a principal-agent problem. A principal-agent problem occurs between an individual or a group of people and the entity authorized to move on their behalf. This authorized entity may have behaved in a way that is not in the principal's best interest.
Let us cite some examples.
To further clarify what mismatch risks mean, let us cite some scenarios. First, let us say that there was a mismatch risk in a swap contract. It means that there is a chance that a swap dealer, who acts as the middleman in the situation, is not capable of finding the best counterparty for a swap transaction.
In another point of view, an investor has a mismatch risk when he chooses investments that do not match the situation, risk tolerance, means, and more.
Also, there is a company mismatch risk if they get involved with
a transaction or hold assets that are not necessary for their business.
Tell me more about mismatch risks.
The examples mentioned earlier are some of the most common
mismatch risks: investor's investments, company cash flows, and swap
transactions. Entities experience mismatch risks when they engage in
transactions or hold assets that do not match their needs. Let us elaborate
more on these three.
One of three: Swaps
Because of various factors, swap banks or other intermediaries may find it challenging to look for a swap transaction counterparty. For instance, a company may need to swap with a massive notional principal. However, it might be hard to find a counterparty willing to take the other side of the transaction. In this situation, potential swappers might not be enough.
Let us cite another example. In this scenario, the swap is very
particular with their terms. Counterparties do not actually need those terms
exactly. So, to benefit from the swap, the initial company should be willing to
agree with the terms being altered. This might lead to an imperfect hedge. It
can also lead to a strategy that is not suitable for particular forecasts.
Two of three: Investors
There is a mismatch risk if the investor's investment type and
horizon are not suitable for each other. Let us say that the investor about to
retire has a short investment horizon massively invests in biotech stocks. Most
of the time, investors with short investment horizons do not invest in
speculative investments. Instead, they focus on fixed-income securities. In
another perspective, there is a mismatch risk if a risk-averse investor invests
in risky and aggressive stocks.
Three of three: Cash flows
There is a mismatch risk in companies if the assets and
liabilities do not match. Hence, it may create a cash flow that is not suitable
for the liabilities. Let us say that a company has an asset that only makes
semi-annual payments. However, the company is responsible for paying rent,
utilities, suppliers, and employees every month. Making monthly payments is not
an easy task if their asset only makes semi-annual payments.
When we say mismatch risk, we refer to the potential for the losses that arise because of interests, financial capacity, or market views that are not suitable for each other. It may happen when swap dealers can't find a counterparty for the swap, an investor's investment does not match his needs, and a business cash flow does not match its liabilities. If the one end agrees with minor modifications of expectations and goals, mismatch risk can be lowered.