Dollar duration tells you how much a bond’s value will change in dollars when market interest rates shift. Bond fund managers use it to gauge how much interest rate risk their portfolio has. It’s one of the ways to measure a bond’s duration, focusing on how sensitive the bond’s price is to interest rate changes, and it expresses those changes in actual dollar terms.
Understanding about Dollar Duration
Dollar duration, also known as money duration or DV01, estimates how much a bond’s value will fluctuate with interest rate changes. However, since the bond value and interest rates don’t have a straightforward linear relationship, money duration isn’t a perfect gauge of interest rate sensitivity. It’s most reliable for minor interest rate shifts.
Dollar duration tells you how much a bond portfolio’s value shifts with a 100 basis point change in interest rates. It’s also known as DV01 (dollar value per 01). Just a heads up, 0.01 equals 1 percent, which is the same as 100 basis points (bps). To figure out a bond’s DV01, you’ll need its duration, the current interest rate, and how much interest rates are changing.
Dollar Duration = DUR x (∆i/1+ i) x Pwhere:
- DUR = the bond’s straight duration
- ∆i = change in interest rates
- i = current interest rate; and
- P = bond price
Money duration is all about the price of a single bond, but when you add up the weighted dollar durations of all the bonds in a portfolio, you get the portfolio’s money duration. This concept isn’t just for bonds; it can also be used for other fixed income products that change in price when interest rates fluctuate.
The Limitations
Dollar duration isn’t perfect. For one, it’s based on a negatively sloped linear line and assumes the yield curve shifts in parallel, so it’s just an estimate. But if you’ve got a big bond portfolio, that estimate isn’t as much of a drawback. Another issue is that money duration calculations assume bonds have fixed rates and regular payments, but interest rates can vary due to market conditions and the use of synthetic instruments.