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P2.T5.111. MBS dollar roll

David Harper CFA FRM

David Harper CFA FRM
Staff member
The first question below took me a long time to write. Please understand that it is not a typical FRM question; it's not quite like a question you would expect to see. Rather, the laborious setup is merely to refresh the dollar roll concept. It's not like you need all of that paragraph, but I had to work through the pricing issue to understand the AIM, so I hope you find it helpful. Thanks, David

AIMs: Explain a dollar roll transaction, how to value a dollar roll, and what factors can cause a roll to trade “special.” Relate the pricing of mortgage products to developments in MBS markets. Explain the purpose of cash flow structuring of mortgage backed securities.


111.1. In the agency mortgage-backed security (MBS) market, the difference between the front month (i.e., an initial purchase price) and back month (i.e., a resale price) is the price of the dollar roll. The price of the dollar roll is an implied financing rate: the investor who buys the securities in the front month and then sells them in the back month is receiving collateral and loaning cash, in a manner similar to a repo transaction. For example, if the investor purchases securities at a price of $X, and receives $C during the roll period, then sells them back at $Y, the implied financing rate is (Y+C)/X - 1. The roll "trades special" if the financing rate is lower than (more favorable than) can be gotten in the repo market. Which of the following dynamics is LEAST LIKELY to cause the roll to trade special, or to even further lower the implied financing rate, EXCEPT for:

a. Heavy or increased issuance by originators in the back month pushing down the price for that settlement date
b. Stronger demand in the front month for deal collateral, pushing up the front month price
c. As the investor who buys the securities receives the principal and interest during the roll period, the investor incurs prepayment risk
d. Increased demand for mortgage-backed securities (MBS) from investor that prefer to have securities (as opposed to forward-settlement TBA transactions) on their books

111.2. With respect to the pricing of mortgage products, each of the following is true EXCEPT:

a. The most important (primary) influence on consumer mortgage rates, as with real estate, is supply and demand in local markets
b. As the loan note rate increases, the "points" charged should decrease; above a certain note rate, points will be rebated to borrower (a.k.a., negative points)
c. Consumer borrowing rates have become increasingly linked with capital market rates and flows
d. The calculation of the optimal MBS coupon for private (non-agency; e.g., jumbo) pool is conceptually similar to the approach for agency pools except for the lack of a guarantee fee (g-fee)

111.3. Which of the following is TRUE about the purposes of cash flow structuring of mortgage-backed securities?

a. Cash flow structuring reduces the total interest rate sensitivity (e.g., duration) in the pool
b. Cash flow structuring translates a pool's cash flows and risks into securities with different (various) cash flows and risk features
c. Cash flow structuring can minimize the impact of idiosyncratic risk by way of diversification
d. Cash flow structuring can generally convert a pool with less desirable loans into tranches that are all more desirable