What is Dollar Roll Transaction?
A dollar roll is the same as the reverse repurchase agreement (buying and selling securities at a higher price in the future at a specific date). Short term liquidity is provided by the dollar roll as it gives cash to the initiators.
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Some important terms used:
- The present or the early month is known as a front month and the other later is called a future month or back month.
- The drop between the months is mostly positive (a front month is higher than the future)
- Buying the front month and selling the back month is called “buying the roll” and vice versa as “selling the roll”
How a Dollar Roll Transaction Works?
Two TBA (to be announced) trades consists in dollar roll transaction. The roll seller simultaneously buys and sells an MBS with the same TBA characteristics and at a specified price but with different contract dates and hence derived the name as dollar roll. Most commonly used contract dates are usually for the short term of one month or three months. The difference in the prices over the front and future months is known as a drop. The drop is said to be “on special” when the drop is very large. Drop can happen for different reasons like large collateralized mortgage obligation deals which leads to an increase in the demand for mortgage pass-through securities, or unexpected fallout of mortgage closings in a mortgage originator’s pipeline. In this case, the financial institution rolls the trade for any future dates. The drop is directly proportional to the shortage of available securities in the current month.
As the dollar roll trades are TBA the economics of the transaction depends on whether the investors want to buy trade in the current month or settle it in future months. The other side of the trade, the sell-side trade counterparty, benefits by not having to deliver the mortgage-backed securities in the current month, and thus retains the interest payments and principal which would have been passed to the holder of securities if the trade took place.
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Example to show the working
In this example, the roll seller sells an MBS for May 16 settlement and again buys it for June 16 settlement, at a par amount of $1 million from the agency called “Fannie Mae” MBS. The coupon rate is 5% and the loan term is for the period of 30 years. The front-month and future month prices are 102-16 and 102-2 per $100 of par amount, respectively. The “drop” in this transaction is 100 16 32 – 100 2 32 = 14 32 per $100 par value is positive because of two reasons First, the returned MBS pool within the future-month TBA contract may have less prepayment behavior and lower value than the original MBS sold in the front-month contract. Second, after the front-month of the dollar roll transaction, the roll seller gives up the ownership of the MBS and any interest and principal payments. This differentiates the dollar roll from an MBS repo transaction. In an MBS repo trade, the identical MBS pool needs to be returned, and therefore the original owner collects principal and interest payments during the term of the repo.
Author: Trushali Hindocha
About the Author:
Trushali completed her graduation in Computer science and engineering, she has worked as Associate Consultant in Atos Syntel for 18 months. She is currently pursuing MMS in Finance from KJ Somaiya Institute of Management Studies and Research, Mumbai. She is also well acquainted with Tableau and programming languages like Python and R for Data Analytics.
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