Drop

What is a Drop?

Drop, otherwise called the roll price, is the difference in price between settlement months while executing mortgage-backed security (MBS) dollar roll trade. Like a repurchase agreement, dollar roll trades act as the primary channel for mortgage security borrowing and lending in the to-be-announced (TBA) market. In particular, the drop is the price difference between when the investor sells the MBS and repurchases it sometime in the future.

BREAKING DOWN Drop

The drop is a price spread between the current month and a future month for a pool of mortgage-backed securities. Spread is the difference between the bid and the requesting price from a security or asset.

The drop sees primary use in the to-be-announced (TBA) marketplace. This marketplace is where forward-settling mortgage-backed security (MBS) trades settle. The term TBA is derived from the way that the genuine mortgage-backed security that will be delivered to satisfy a TBA trade isn't designated at the time the trade is made. The securities are announced 48 hours prior to the laid out trade settlement date.

To-Be-Announced Market and Drop

Pass-through securities issued by Freddie Mac, Fannie Mae and Ginnie Mae trade in the TBA market. A pass-through security is backed by a bundle of underlying assets, like mortgages. A servicing intermediary gathers regularly scheduled payments from issuers and, in the wake of deducting a fee, transmits or passes them through to the holders

Inside the TBA market, there may likewise be dollar roll transactions in pass-through securities. In these trades, the buy-side consents to sell off in the current month and buy back in a future month. 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 special assignment is due to the investor having the option to keep up with mortgage exposure and invest and earn interest on the proceeds from the sale of the MBS.

Minor departure from the traditional dollar roll trade include purchasing comparable securities, as opposed to indistinguishable securities during the main purchase.

The size of the drop is impacted by demand for mortgage pass-through securities and the volume of mortgage closings in a mortgage originator's pipeline. On the off chance that a financial institution has more sell trades in a given month than why they can deliver securities, they should roll those trades into a future month. The lower the number of available securities in a given month, the higher the drop, or the spread in price differences, will be.

The drop is frequently positive, due to the economic value of taking delivery of the mortgage-backed security (MBS) and partaking in the revenue produced from interest or principal payments.

Advantages and disadvantages of the Drop

The two buyers and sellers can profit from the drop. The buy-side counterparty will invest the funds that in any case would have been required to settle the buy trade in the current month until the agreed upon future buy-back. The sell-side counterparty benefits by not conveying the pass-through securities, which they could somehow have shorted or committed to another trade, in the current month.

A superb method for looking at the economic benefit of a dollar roll transaction, and the subsequent drop, relies upon if settling the MBS and earning the coupon income, or conceding settlement into the next month and earning the cash return, will be the best utilization of funds.