Adverse Selection Between Buyers and Sellers in Mortgage Dollar Rolls

Summary

The document questions a research paper’s assumption that adverse selection tied to cheapest-to-deliver mortgage-backed securities affects the seller of a dollar roll more than the buyer. The paper’s stated rationale is that the buyer chooses the delivered security and that rolls are often traded near front-month settlement, when both sides can assess which pools are cheapest. The questioner argues these points may not eliminate the buyer’s exposure: the trade need not occur close to settlement, and delivery discretion may not prevent unfavorable pools from being selected.

The discussion asks whether there is stronger practical justification for assigning more adverse-selection risk to the seller, or whether the asymmetry is a simplifying research assumption. It supplies no answer, data, or market evidence to settle the issue. Assessing the claim would require examining delivery options, pool characteristics, timing, and how information and bargaining power are distributed between counterparties; the document itself leaves those matters open.

Key ideas

• The question concerns adverse selection in mortgage-backed security dollar rolls.
• The cited rationale emphasizes the buyer’s choice of delivered security and trading near settlement.
• The author questions whether delivery discretion and settlement timing sufficiently protect the buyer.
• The document does not provide empirical evidence or resolve which counterparty bears more risk.
• Evaluating the assumption would require analyzing pool selection, timing, and information differences.

Tags

# Does adverse selection affect roll seller more than buyer?


# Does adverse selection affect roll seller more than buyer?












This paper that analyzes the determinants of dollar roll specialness seems to make the underlying assumption that adverse selection related to CTD pools affects the roll-seller more than the roll buyer. They justify it by saying the below:

We expect this risk to be limited because (1) the roll buyer has the last say on the delivered CUSIP, and (2) the roll trade date is usually close to the front-month settlement date when both counterparties have a good idea on the cheapest MBS in practice.

But, both of the above points don't seem like strong evidence to believe that the roll seller suffers more from adverse selection (i.e. the roll trade does not necessarily need to be close to the front-month settle date and having last say won't necessarily stop pools with unfavorable characteristics from being delivered to the buyer)

As such, would like to understand if there is further justification for believing the roll seller should be more affected by adverse selection than the buyer? Or is this more of a simplifying assumption for the purposes of a research paper, rather than anything truly practical?

Shown in full with attribution under the source's licence. Licence: CC BY-SA 4.0 (Stack Exchange)

This summary was written by Stratmill's research agent from the original; it is not a copy of the source.