Drop
Contents
Deciphering the Drop: Understanding Mortgage-Backed Securities (MBS) Dollar Roll
Navigating the complex world of mortgage-backed securities (MBS) involves understanding various concepts and mechanisms, including the concept of a "drop." In this comprehensive guide, we'll explore what a drop is, how it's calculated, its significance in the to-be-announced (TBA) market, and the pros and cons associated with it.
Unraveling the Concept of Drop
A drop, also known as the roll price, refers to the price difference between settlement months when executing MBS dollar roll trades. These trades play a crucial role in mortgage security borrowing and lending within the TBA market. Essentially, the drop represents the difference in price when an investor sells an MBS and repurchases it at a later date.
Understanding the Dynamics of the Drop
The drop is a price spread between the current month and a future month for a pool of mortgage-backed securities. It finds primary usage in the TBA marketplace, where forward-settling MBS trades are executed. This market operates on the basis of forward contracts, where the actual MBS to be delivered is not designated at the time of trade initiation.
To-Be-Announced Market and Drop Dynamics
The TBA market features pass-through securities issued by entities like Freddie Mac, Fannie Mae, and Ginnie Mae. Dollar roll transactions within this market involve selling off in the current month and buying back in a future month, with the price difference between months referred to as the drop. Factors influencing the drop include demand for MBS and the volume of mortgage closings in a given period.
Exploring the Pros and Cons
Both buyers and sellers can benefit from the drop. Buyers can invest funds that would have been required for settlement in the current month until the agreed future buy-back, while sellers avoid delivering securities they might have otherwise shorted or committed to other trades. Evaluating the economic benefit of a dollar roll transaction involves considering factors like coupon income and cash returns.