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This is a basic question. But I wanted to understand how a TBA short (buying the dollar roll) is economically short an MBS? For example, if an investor believes a specific coupon is rich, they could buy the dollar roll. How would they benefit from that coupons TBA reducing in price?

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Buying/selling dollar rolls does not have the same economic exposure as going long/shorting MBS. The following example hopefully clarifies this. Suppose you short (sell) a TBA on June 1st for the front month. Then, as you approach settlement day: (1) You can buy the TBA back and cover the short; (2) Plan to deliver pools (which you already have access to) to the buyer; and (3) Buy the June/July roll for that coupon which covers your short for the front month and rolls it forward to the back month. Note that the dollar roll consists of two simultaneous transactions: a purchase/sale in the front month coupled with a sale/purchase in the back month. The dollar roll is viewed as a financing transaction rather than a naked long/short exposure.

There is no straightforward connection between believing a coupon is rich and buying the roll. Rather, the roll price is determined by both front and back month TBA prices, which in turn are a complicated function of supply/demand technicals for the two months, prepayment expectations, and miscellaneous other factors.

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  • $\begingroup$ Thanks. To understand, if an investor thinks a coupon is rich (over several months) would they then sell the TBA and then continue buying the roll there after? Even though buying the roll isn’t economically the same as shorting a TBA. $\endgroup$
    – Jojo
    Jun 30 at 10:26
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    $\begingroup$ What you said is correct but the example was really constructed to illustrate the difference between shorts and dollar rolls. IRL, an outright short of a rich coupon would also take on a lot of duration risk. More focused shorts would target shorting the MBS basis and/or trading the appropriate coupon swaps and butterflies. $\endgroup$
    – Sharad
    Jul 1 at 13:48
  • $\begingroup$ Thanks. Even if the investor uses those trades, wouldn't they be at some point faced with going from a TBA short to buying the roll? For eg if an investor is in a FN 4.5/2 swap for 3 months, then wouldn't they need to switch from the short 2 TBA in the front month to buying the 2 roll for the back months? I understand the trade is likely constructed to be duration neutral, but does the switch from long 4.5 TBA/short 2 TBA in FM to selling 4.5 roll/buying 2 roll need to be accounted for? $\endgroup$
    – Jojo
    Jul 4 at 20:56
  • $\begingroup$ Would it be better to post the above question? Just hoping to understand how to think about this. Thank you $\endgroup$
    – Jojo
    Jul 6 at 21:27
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    $\begingroup$ If the 4.5/2 coupon swap doesn't meet your target (and you don't want to deliver 2s, receive 4.5s) and you want to roll it forward, then you are correct that rolls need to be accounted for. The investor doesn't necessarily experience these mechanics as the trading desk will just offer a single quote for rolling the swap but behind the scenes the rolls for the individual coupons will be involved. $\endgroup$
    – Sharad
    Jul 12 at 13:41

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