Dollar Duration
Candlefocus EditorIn the bond market, true duration is measured by the number of points the price of a bond will rise or fall for each one-point change in interest rates. dollar duration represents the equivalent change in the price of the bond portfolio when rates move, calculated in nominal or dollar terms.
To calculate in detail, the dollar will be multiplied by the modified duration and then multiplied by the expected change in interest rates. If a bond fund manager holds a portfolio with a duration of 2.5, and interest rates rise by 50 basis points – the expected drop in the portfolio’s value will be 2.5 * 0.5 = 1.25%. This can be further multiplied against the market value of the bond portfolio. For instance, should a bond portfolio worth $10 million, the expected change in value due to an increase in interest rates will be approximately $12.5 million.
Using dollar durations, bond fund managers can gauge the rate at which the firms will likely be able to buy or sell bonds in order to adjust for anticipated changes in interest rates. The benefit of using dollar duration is that it measures the impact of changes in interest rates in dollar terms, which makes it easier to comprehend the expected changes to the market value of the bonds. It can also be used to measure the adjustment in yield for individual bonds.
Although the dollar duration is a useful metric for measuring the impact of interest rate variations to the value of bonds, one of the main limitations of the measure is that it is only an estimation. It assumes that bonds will have fixed yields throughout the course of their life, with regular payments of principal and interest. This makes it difficult to take into account potential fluctuations in the market value of the bonds over time. Additionally, this metric is not able to take into account potential changes in credit spreads or the liquidity or credit quality of the bonds.
In summary, dollar duration is a convenient metric used by bond fund managers to measure the expected impact of changes in interest rates on the portfolio’s value. It is important to note, however, that this metric does have limitations, and should not be relied on for precise measurements.