I was able to fix this issue. Turns out my Web Service adds a namespace declaration to the xml that gets returned.
Steps to solve the issue:
1) Examine the xml that is being generated by the Web Service. You can do this by trying the Test button on HTTP Services>Add screen.
2) Declare a namespace prefix (xmlns:r="
http://www.test.com/TEST_DATA_SERVICE") in the Form source code. You can do this by going to Advanced>Edit Source.
3) Change the XPath expressions of the Dynamic Data Dropdown:
Items = //r:role (instead of //role)
Label = r:roleName (instead of roleName)
Value = r:roleName (instead of roleName)
Hope that helps others having issues with Dynamic Data Dropdown.