What Is a Dollar Roll?

A dollar roll is a sophisticated trade in the mortgage-backed securities (MBS) market that provides benefit to a trader when those securities actually decline in value. The dollar roll also gives the initiator cash to work with for a short period of time.

Key Takeaways

  • A dollar roll is a sophisticated trade in the mortgage-backed securities markets.
  • These trades profit from a drop in securities prices.
  • They begin with a sell transaction and carry the obligation of a buy transaction at some point in the future.
  • Most of these trades last only one month.

How a Dollar Roll Transaction Works

In the world of MBS a dollar roll is somewhat similar to selling stocks short. Just as a short-seller in the stock market profits from falling stock prices, a dollar roll buyer can profit from a drop in the price of mortgage-backed securities.

To accomplish this an investor much initiate a repurchase transaction in the mortgage pass-through securities market in which they, the buy-side trade counterparty of a "to be announced" (TBA) trade agrees to sell of that same trade in the current month and to a buy back the same trade in a future month.

In a dollar roll, the initiating investor gets cash back from their sale. They can then invest the funds that otherwise would have been required to settle the buy trade in the current month until the agreed upon future buy-back. The other side of the trade, the sell-side trade counterparty, benefits by not having to deliver the mortgage-backed securities in the current month, thus retaining the principal and interest payments that would normally be passed through to holder of those securities.

The initiator of the dollar roll is hoping that they can either buy back the securities at a lower price, or make a short-term profit from the money gained from the dollar roll, or preferably both. The dollar roll transaction is conducted in on securities that have the same product and the same coupon rate but with different contract date, hence the term roll. The most common and most liquid contract dates are one-month and three-month rolls. 

The price difference between months is known as the drop. When the drop becomes very large, the dollar roll is said to be "on special". This might happen for several reasons, including large collateralized mortgage obligation deals that increase the demand for mortgage pass-through securities, or unexpected fallout of mortgage closings in a mortgage originator's pipeline. In both cases, financial institutions might have more sell trades in the current month than they are able to deliver securities into, forcing them to "roll" those trades into a future month. The greater the shortage of available securities in the current month, the larger the drop becomes. Investors that could anticipate such conditions could profit from a dollar roll transaction.

Rolls can be purchased by a new transaction where the originator wishes to push their hedge out to a further date. For example, if an investor sells an outright contract and wishes to push it out one month, they would then have to "buy and sell" in the one-month roll market. Because there is no increase or decrease in the outright position, dollar rolls carry no, or very little, duration risk. It is simply an extension of a contract, not a new contract.