A Closer Look At Dollar Rolls In The TBA-MBS Market

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One of the more confusing MBS topics is the concept of "dollar rolls."  While it seems esoteric, secondary markets people are implicitly considering the dollar roll market every time they make the judgment to sell one month's settlement over an earlier or later month.  A "roll" is a transaction where a TBA security is bought or sold, and an offsetting trade for a different settlement month is executed simultaneously.  For example, buying 1mm Fannie 3.5s in February and simultaneously selling 1mm Fannie 3.5s in March is trading in a dollar roll.  Rolls are quoted by the price difference between months; as an example, if the price for FN 3.5s in February is 100-00 (par) and the price in March is 99 24/32s, the difference (or "drop") is 8/32s.

A few other terms will be helpful:

  • The early month is referred to as the "front month," and the later month is the "back month."
  • The drop between months is almost always positive (meaning that the front month usually is the higher price)
  • Buying the front month and selling the back month is "buying the roll," while selling the front month and buying the back month is "selling the roll." (To avoid confusion, remember that the person buying anything will make money if it goes up in price; a relative decline in the price of the back month would cause the drop to expand.)

The reason that the drop is usually positive is that there is economic value to taking delivery of securities (in this case, MBS pools) and holding them for a horizon period, as opposed to buying it for the horizon date.  The value results from carry (i.e., interest accrued from holding the securities over the holding period net of funding costs) and reinvestment income; the holder also accepts the monthly paydowns resulting from scheduled and unscheduled principal payments (i.e., amortizations and prepayments).  (Note that the situation is reversed in the commodities markets.  For example, gold does not pay interest, but can be costly to store; therefore, a buyer of bullion would pay more to buy it for a later settlement.)

Next time:  calculating a roll's "cost of funds," and understanding the technical factors that drive the dollar roll market.