What is 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.
Factor of Inaccuracy in Dollar Duration
Dollar duration is not an accurate measure of the effect of interest rates on bond prices, as the relationship between the two is not linear.
It means that the aforementioned formulas can accurately predict price changes in bonds for given interest rates only for small changes.
Limitations of Dollar Duration
Dollar duration has its limitations. Firstly, because it is a negative sloping linear line and it assumes the yield curve moves in parallels 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. However, interest rates for bonds differ based on market conditions as well as the introduction of synthetic instruments.
Advantages of Dollar Duration
The following are some advantages of dollar duration.
DV01 enables banks and other financial institutions to quickly assess the impact of change in yields on their portfolio in dollar terms. Thus they can be well prepared with different scenarios on the impact of yield movements on the Market Value of their Portfolio.
It is relatively simple to calculate and easy to understand.
DV01 is additive in nature, which means that one can calculate the same for each bond in the portfolio and aggregate them to derive the portfolio DV01.
Disadvantages of Dollar Duration
Let us discuss some disadvantages of dollar duration.
The biggest shortcoming of DV01 lies in its assumption of a parallel shift in the yield curve , which is more theoretical in nature than in the real world. The yield curve never shifts parallel. The impact of yield movement varies based on maturity and usually short maturity. Fixed Instruments yield change faster than long-maturity Fixed Instruments. By assuming a parallel shift, the impact suggested by DV01 on the value of Bond varies from the actual impact on the price of the Bond.
Hedging undertaken using standard DV01-neutral hedge fails to provide a perfect hedge due to the imperfect one to one relationship caused by rising and fall of basis points across different instruments used for hedging.
The Dollar Value of a Basis Point (DV01) is the dollar exposure of a Bond Price for a change in yield of a single basis point. It is also the duration times the market value of the Bond and is additive across the entire portfolio and is an important tool used by Portfolio managers and Bond Dealers to measure the linear relationship between Bond Prices and Bond yield impact.