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 several different measurements of bond's duration, As duration measures quantify the sensitivity of a bond's price to interest rate changes, dollar duration seeks to report these changes as an actual dollar amount.
Definition: Dollar duration measures the change in the value of a bond in dollar terms due to changes in market interest rates. It is used by professional bond fund managers to approximate the interest rate risk of a portfolio. Dollar duration is one of several methods to measure bond duration, which gauges the sensitivity of a bond's price to interest rate changes, but dollar duration reports these changes in actual dollar amounts.
Origin: The concept of dollar duration originated in the mid-20th century as financial markets evolved and bond investing became more widespread. Investors needed a more intuitive way to measure the impact of interest rate changes on bond values, leading to the development of dollar duration as a key risk management tool.
Categories and Characteristics: There are two main types of dollar duration: modified duration and effective duration. Modified duration assumes constant cash flows and is suitable for fixed-rate bonds; effective duration considers that cash flows may change with interest rates, making it suitable for floating-rate bonds and bonds with embedded options. Modified duration is simpler to calculate but ignores the impact of interest rate changes on cash flows; effective duration is more complex but provides a more accurate reflection of interest rate risk.
Specific Cases: Case 1: Suppose a bond fund holds a portfolio of bonds worth $10 million with a modified duration of 5 years. If market interest rates rise by 1%, the fund's value would decrease by approximately $500,000 ($10 million x 0.05). Case 2: An investor holds a floating-rate bond with a face value of $1 million and an effective duration of 3 years. If market interest rates fall by 1%, the bond's value would increase by approximately $30,000 ($1 million x 0.03).
Common Questions: Investors often ask: 1. What is the difference between dollar duration and regular duration? Answer: Dollar duration expresses the impact of interest rate changes on bond value in dollar terms, while regular duration typically expresses it in years. 2. How to choose between modified duration and effective duration? Answer: Modified duration is suitable for fixed-rate bonds, while effective duration is suitable for floating-rate bonds and bonds with embedded options.
