Explanation:
The correct answer is A.
Drop is the price difference between the front month (month of sale) and the back month (month of purchase).
Step 1: Calculate the sale proceeds (front month):
The bonds are sold for 100-08, hence:
Proceeds = $10m × (100 + 8/32)/100 = $10m × 100.25/100 = $10,025,000
Step 2: Calculate the repurchase cost (back month):
Purchasing the security at par, bearing in mind that the security has experienced a 2% paydown:
Cost = $10m × (1 − 2%) × (100/100) = $10m × 0.98 = $9,800,000
Step 3: Calculate the drop:
Drop = Sale Proceeds − Repurchase Cost
Drop = $10,025,000 − $9,800,000 = $225,000
Why the other choices are incorrect:
$22,500,000): This is implausibly large and would not correspond to any reasonable calculation related to the dollar roll.$800,000): This does not match the computed difference between the front-month sale price and the back-month purchase price adjusted for paydown.$250,000): Close in magnitude but does not correctly account for the 2% paydown reduction on the repurchase side.Q.3457 A fund holds $10 million nominal of the GNMA 5.5% 30-year bond. It enters into a one-month dollar roll with a repo dealer bank in which it sells the security at a price of 100-08 and buys it back at a forward price of par. Assuming that the security experiences a 2% paydown (scheduled principal plus prepayments) during the term of the trade, estimate the value of the drop.
A
$225,000
B
$22,500,000
C
$800,000
D
$250,000
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