What is the 'Dollar Duration'
The dollar duration measures the dollar change in a bond's value to a change in the market interest rate. The dollar duration is used by professional bond fund managers as a way of approximating the portfolio's interest rate risk. Dollar duration is one of the several different measurements of bond duration.
As duration measures the sensitivity of a bonds price in interest rate changes, dollar duration seeks to give these changes an actual dollar amount.Â
BREAKING DOWN 'Dollar Duration'
Dollar duration is based on a linear approximation of how a bond's value will change in response to changes in interest rates. The actual relationship between a bond's value and interest rates is not linear. Therefore, dollar duration is an imperfect measure of interest rate sensitivity, and it will only provide an accurate calculation for small changes in interest rates.
Mathematically, the dollar duration measures the change in the value of a bond portfolio for every 100 basis point change in interest rates. Dollar duration is often referred to as DV01Â (dollar value per 01). Remember 0.01 being 1 percent which is 100 basis points. To calculate the dollar duration of a bond you need to know its duration, the current interest rate and the change in interest rates.
Â Â Â Â Â Â Â Â Â Â Â Â Â Dollar Duration =Â DUR x (âˆ† i/1+ i) x P
While dollar duration refers to an individual bond price, the sum of the weighted bond dollar durations in a portfolio is the portfolio dollar duration. Dollar duration can be applied to other fixed income products such as forwards, par rates, zero coupon bonds and many more.Â
Limitations
Dollar duration has its limitations. Firstly, because it is a negative sloping linear line and it assumes the yield curve moves in parallelsÂ the result is only an approximation. However, if you have a large bond portfolio, the approximation becomes less of a limitation. Another limitation is that the dollar duration calculation assumes the bond has fixed rates with fixed interval payments.Â
Comparisons
Dollar duration differs from MacaulayÂ duration and modified duration in that modified duration is a price sensitivity measure of the yield change, meaning it is a good measure of volatility and Macaulay duration uses the coupon rate and size plus the yield to maturity to assess the sensitivity of a bond.Â
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