Drop

Reviewed by Vineeth | Updated on Aug 27, 2020

Introduction

Drop is also referred to as the roll price. Drop is the price difference between the months of settlement when performing dollar trades that are backed by mortgage security. It is somewhat similar to a repurchase contract.

Dollar trades will serve as the basic channel for mortgage security lending and borrowing in the TBA (to be announced) markets. Particularly, the drop is the difference in price between the investor selling the mortgage-backed securities and repurchasing the same at a later date.

Understanding Drop

A drop is the difference of price spread between a future month and the current month for a collection of mortgage-backed securities. Spread is the difference between the asking and bidding price of an asset or a security.

The drop has primary usage in the TBA marketplace. The to be announced marketplace are the markets where forward-setting mortgage-based securities are generally traded and settled.

The term to-be-announced is obtained from the typical mortgage-backed security which will be delivered to accomplish a to-be-announced trade, which is not indicated when the trade is actually made. The securities are announced exactly two days (forty-eight hours) before the trade settlement date is established.

Advantages and Disadvantages of Drop

Both sellers and buyers can make a profit out of a drop. The buyer-side counterparty will get to invest a fund, which otherwise will be needed to settle the buy trade in the present month till the future buyback which was pre-agreed.

The seller-side counterparty will be benefited by not needing to present the pass-through assets or securities that they may otherwise have committed or shorted to another trade, in the present month.

A good to verify the monetary advantage of dollar roll transactions, and the drop resulting, relies on whether settling the mortgage-backed securities and earning income through a coupon or postponing the settlement to a future month and making cash, would be the best utilisation of funds.