Key Takeaways
- Measures bond price change per yield change in dollars.
- Expresses interest rate risk in absolute currency terms.
- Useful for portfolio risk aggregation and hedging.
- DV01 scales dollar duration to 1 basis point shifts.
What is Dollar Duration?
Dollar duration measures the absolute dollar change in a bond's price for a small change in yield, typically 1%, providing a clear monetary estimate of interest rate sensitivity. Unlike percentage measures, it expresses risk in actual currency units, helping you understand potential portfolio value fluctuations.
This concept builds on face value and modified duration to convert percentage price sensitivity into dollar terms, making it essential for fixed-income investors managing risk and hedging strategies.
Key Characteristics
Dollar duration offers a straightforward way to quantify bond price sensitivity. Key features include:
- Monetary measure: Expresses interest rate risk in dollars, not percentages, which aids practical risk management.
- Linear approximation: Assumes small yield changes and parallel shifts in the yield curve.
- Related metrics: Includes terms like DV01, which measures dollar change per 1 basis point yield move.
- Portfolio aggregation: Enables summing individual bond dollar durations to assess total interest rate exposure.
- Limitations: Less accurate for large yield moves due to bond convexity effects.
How It Works
Dollar duration is calculated by multiplying the bond's modified duration by its price and the yield change factor, typically 1%. This converts the percentage sensitivity into an absolute dollar change.
By using this metric, you can estimate how much a bond or portfolio’s value will change with interest rate fluctuations, supporting strategies like immunization to protect against rate risk. It works best for small, parallel shifts in yields, providing a first-order estimate of price impact.
Examples and Use Cases
Understanding dollar duration helps in various investment scenarios, including bond portfolio management and risk hedging:
- Bond ETFs: Investing in funds like BND allows you to monitor aggregate dollar duration exposure across many bonds.
- Interest rate hedging: Portfolio managers use dollar duration to balance positions against rate changes, minimizing losses.
- Duration matching: Aligning a portfolio’s dollar duration with liabilities can be part of managing a J-curve effect in fixed income.
- Examples: A bond priced at $25 with a known modified duration can have its dollar duration calculated to predict sensitivity to yield changes.
Important Considerations
While dollar duration is a valuable tool, it assumes a linear price-yield relationship and parallel yield curve shifts, which may not hold during volatile market conditions. Large interest rate movements can cause inaccuracies due to bond convexity.
For more precise risk assessment, especially with complex bonds or larger yield changes, complement dollar duration analysis with other metrics and consider consulting resources like our best bond ETFs guide for diversified fixed-income exposure.
Final Words
Dollar duration offers a precise dollar-value measure of bond price sensitivity to yield changes, crucial for managing interest rate risk. To apply this effectively, calculate the dollar duration for your portfolio and use it to assess potential losses or hedge positions accordingly.
Frequently Asked Questions
Dollar Duration measures the absolute dollar change in a bond's price for a small change in yield, typically 1%. It provides a monetary estimate of how sensitive a bond's price is to interest rate changes.
While Modified Duration expresses price sensitivity as a percentage change, Dollar Duration converts that sensitivity into actual dollar terms. This helps investors understand risk in currency units rather than percentages.
DV01, or dollar value of 01 basis point, measures the price change for a 0.01% yield shift and is essentially Dollar Duration scaled down. Specifically, DV01 equals Dollar Duration divided by 100.
One common formula is Dollar Duration = Modified Duration × Bond Price × 0.01, which estimates the dollar change for a 1% yield change. Variations exist based on context, but all relate price, duration, and yield change.
Dollar Duration helps bond managers aggregate the total interest rate risk of a portfolio by summing the dollar durations of individual bonds, enabling better risk assessment and hedging strategies.
Dollar Duration assumes a linear relationship between price and yield, so it works best for small, parallel yield changes. For large or non-parallel shifts, the approximation may be less accurate.
If a bond’s price rises by $0.50 when yield drops 2 basis points, DV01 is calculated as $0.25 per basis point, meaning the bond price changes by $0.25 for every 0.01% yield change.
