Dollar Roll
What Is a Dollar Roll?
A dollar roll is a bearish trade employed in the mortgage-backed securities (MBS) market that benefits a trader when those MBS securities decline in value. The dollar roll simultaneously furnishes the initiator cash to work with for a short period of time. In less complex terms, a dollar roll is to sell short MBS.
A dollar roll ought not be mistaken for rolling lapsing derivatives contracts nor a jelly roll, which is an options trading strategy.
How a Dollar Roll Transaction Works
In the world of MBS, a dollar roll is to some degree like selling stocks short. Just as a short-seller in the stock market profits from falling stock prices, a dollar roll buyer can profit from a drop in the price of mortgage-backed securities.
To achieve this an investor will start a repurchase transaction in the mortgage pass-through securities market in which they, the buy-side trade counterparty of a "to be announced" (TBA) trade consents to sell off that equivalent trade in the current month and to a buy back a similar trade in a future month.
In a dollar roll, the starting investor gets cash back from their sale. They can then invest the funds that in any case would have been required to settle the buy trade in the current month until the settled upon future buy-back. The opposite side of the trade, the sell-side trade counterparty, benefits by not conveying the mortgage-backed securities in the current month, subsequently holding the principal and interest payments that would ordinarily be passed through to the holder of those securities.
The initiator of the dollar roll is trusting that they can either buy back the securities at a lower price, or make a short-term profit from the money acquired from the dollar roll, or ideally both. The dollar roll transaction is led in securities that have a similar product and a similar coupon rate however with various contract dates, subsequently the term roll. The most common and most liquid contract dates are one-month and three-month rolls.
Special Considerations
The price difference between months is known as the drop. At the point when the drop turns out to be extremely large, the dollar roll is supposed to be "on special". This could occur because of multiple factors, including large collateralized mortgage obligation bargains that increase the demand for mortgage pass-through securities, or surprising fallout of mortgage closings in a mortgage originator's pipeline.
In the two cases, financial institutions could have more sell trades in the current month than they are able to deliver securities into, compelling them to "roll" those trades into a future month. The greater the shortage of available securities in the current month, the larger the drop becomes. Investors that could expect such conditions could profit from a dollar roll transaction.
Rolls can be purchased by another transaction where the originator wishes to push their hedge out to a further date. For instance, assuming an investor sells an outright contract and wishes to push it out one month, they would then need to "buy and sell" in the one-month roll market. Since there is no increase or reduction in the outright position, dollar rolls carry no, or very little, duration risk. It is basically an extension of a contract, not another contract.
Features
- A dollar roll includes a repo: an initial short sale, to be repurchased sometime in the future.
- A dollar roll is a trade that shorts mortgage-backed securities, profiting when the value of MBS securities falls.
- Most dollar roll trades are short-term in nature, enduring just a long time or less.
