TBA trading gave rise to the dollar roll as a mechanism for dealers to "borrow" pass-throughs they had sold short. In fact, a dollar roll is a contract to buy an amount of TBA pass-throughs for a close delivery date and sell the same amount of the same pass-throughs back for a more distant delivery date. Similar to a Treasury repo trade, the difference in buy-sell prices (the drop) implies a cost-of-carry or financing rate, given a prepayment assumption. (This expected financing rate, then, is subject to prepayment risk.) In general, in quoting the implied financing rate, the market starts with the consensus (mean) of MBS dealer prepayment projections.22 A generic pass-through is "rolling special" when the implied financing rate is below one-month LIBOR or some other relevant financing rate. It is common for a range of 30-year pass-throughs to roll well. Less commonly, the roll may heat up in a few 15-year coupons.
The dollar roll is a critical component of pass-through trading strategies and a vital cause and effect of demand (a hot roll feeds on itself). In general, the stronger the demand for a particular coupon from a particular agency (or sometimes, the tighter the supply), the more likely dealers will be short and have to
21. Roughly 99.9% of TBA trading volume settles in the defined notification and delivery process.
Communication and other technological advances today permit "TBA" trades to be settled for cash or any T + n delivery desired. However, these trades are rare. TBA trades also may have "stipulations," such as pools per million, WAM, or WALA range. Typically, a small markup is charged for "stips." Specified trades, in which the pool numbers are actually known, may trade for any delivery date as well.
resort to dollar roll transactions to settle trades. Demand for the roll drives the implied financing rate down. From their side, investors may use the roll either as a source of financing for TBA trades (so another characteristic of TBA trading is that it can be self-financing), or they may roll securities, taking the financing rate as a "yield sweetener" on their pass-through portfolio. Many of these "sellers of the roll" invest the drop in higher-yielding money market and other short-term securities to further boost yields. (They may keep the roll on for months at a time.) For this reason, how well a pass-through is rolling is an important determinant of its relative value either within a "coupon stack" or across agency pass-throughs of the same term and coupon. Likewise, how well a coupon is rolling is an important determinant of demand for it.
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