Dollar rolls are strategies that involve the repurchase of some type of mortgage-backed security. To a degree, a dollar roll is very similar to a repurchase agreement. The process involves the sale of a security to a buyer, with the agreement that the security will be repurchased at a specified time in the future. One slight variation on the dollar roll strategy involves purchasing a similar security from the buyer of the initial security rather than simply repurchasing the initial security.
As part of the arrangement, the seller in a dollar roll strategy relinquishes any collection of any interest or payments on the principal that are transacted during the period between sale and repurchase. During this interim period, the current owner of the security receives the benefit of any revenue generated. This continues until the repurchase date, at which point the original owner reacquires the security for a slightly lower price that applied to the initial transaction. This lower price is usually referred to as the drop.
The use of a dollar roll strategy can be beneficial for both the buyer and the seller. The buyer of the security has access to the amount of payments collected while the roll is in effect. Often, this not only offsets the lower repurchase price, but also allows the buyer to earn a credible amount of return on the transaction. This is especially true if the security in question carries a healthy interest rate and interest payments are still being made on the outstanding principle.
For the seller of the security, the dollar roll approach can often allow the investor to use the proceeds from the sale to acquire other investments that in turn generate enough revenue to cover the repurchase price of the security that was sold. This in effect allows the seller to make use of the value of the asset to build the portfolio without incurring any permanent loss. While the seller does not have access to any of the interest and principle payments made from the time of the sale until the repurchase, this amount is easily offset from the gains earned from the other investments and the lower repurchase price.
The homeowner who is paying off the mortgage is often not aware that the dollar roll strategy is being used. He or she continues to make payments as usual, and normally has no idea that the holder of the mortgage changed for a short period of time. The only time that a change becomes apparent is when the seller of the security chooses to purchase a similar but different security from the buyer, and the buyer retains control of the security that was originally acquired.