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Had a few questions on MBS Dollar rolls:

  1. How are dollar rolls affected by Interest rate Volatility?
  2. Does the OAS of underlying pools matter to dollar rolls, and if so, how do they affect it?
  3. Does the dollar roll itself potentially impart value to underlying pools? Why does that happen?

Thank You

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1 Answer 1

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  1. It is useful to think from the perspective of the institution who is buying the roll (i.e., purchasing TBAs in the front month and selling in the back month). They are short a delivery option: the pools they receive are governed by SIFMA guidelines that impose virtually no restrictions on many of the collateral characteristics that drive prepayment rates on mortgage pools. Interest rate volatility increases the value of this option (i.e., makes it more likely that the buyer of the roll will be delivered a more negatively convex position) and consequently makes the roll less attractive (increases financing costs for the seller of the roll).
  1. TBA OASs and dollars rolls are tightly interrelated, although figuring out which drives which is often a chicken-and-egg problem. For example: the higher the value of the dollar roll/the lower the financing rate, the richer the TBA gets (lower OAS) because of the more attractive carry. Conversely, a rich TBA (low OAS) invites a greater short base which in turns leads to higher demand for the roll (lower financing costs).

  2. Effectively addressed in (2).

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  • $\begingroup$ Thank you very much. To understand: On 1), when you said with increased rate vol, the deliverable is more likely to be more negatively convex. Is this simply because of the embedded option a mortgage borrower has, which increases in value with rate vol? On 2), I'm a bit confused by this "the higher the value of the dollar roll/the lower the financing rate, the richer the TBA gets". Isn't the value of the dollar roll higher simply because the Front Month TBA is richer (as Dollar roll = Front Month TBA Price-Back Month TBA Price)?Or can there be a difference due to distorted technicals? $\endgroup$
    – Jojo
    May 28 at 18:30
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    $\begingroup$ 1) The delivery option is not directly connected to the prepayment option. The point is that a significant move in interest rates can change issuance patterns and potentially allow the seller to deliver pools that have worse prepayment characteristics than before. 2) Your definition is correct but this difference (technically known as the "drop") fluctuates with market conditions. So, for instance, increasing interest rate volatility may decrease the value of the drop from 4 ticks (say) to 3 ticks (all else being equal). $\endgroup$
    – Sharad
    May 29 at 3:23
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    $\begingroup$ 1) Consider a scenario in which 4s (for example) have been out-of-the-money for several years so that the deliverable consists of seasoned pools. Now, assume mortgage rates rise from 2.5% to 4.5% rapidly over a few months so that 4s start being issued. These 4s will have much larger loan sizes than the old 4s (because of steady home price increases) and will be much more negatively convex. (2) The drop is equal to the carry on the TBA position when the implied financing rate is equal to prevailing short-term investment rates. The last question is more or less answered in (2) above. $\endgroup$
    – Sharad
    May 30 at 1:23
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    $\begingroup$ Your reasoning is correct but what I was trying to suggest in (2) is that it's not always clear which way the causality flows -- is the dollar roll influencing TBA valuations or vice-versa? Also, keep in mind that there are a complex set of other factors influencing dollar roll and TBA pricing so the relationship might break down in practice. $\endgroup$
    – Sharad
    May 30 at 3:06
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    $\begingroup$ Demand/supply technicals, changing interest rate/prepayment expectations, relative-value considerations... $\endgroup$
    – Sharad
    May 30 at 17:16

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