Dollar durations are usually described as the product created when assessing the relationship between the duration of a financial instrument with the price or value of the instrument. Calculating the dollar duration helps investors to understand the yield of a given investment, and thus determine if the security is worthy of continuing to be part of the investment portfolio. The process of calculating a dollar duration is especially helpful when dealing with a fixed income investment, such as a bond.
A dollar duration is determined by comparing the market value with the product of the investment. This approach helps to measure the change in the yield in the event of a change that amounts to at least one percent in the yield. By calculating this duration from time to time, the investor can determine if the investment is remaining on track, and the desired return that is obtained once the security reaches maturity is still possible.
An easy way to understand the dollar duration is to think of it as a way to monitor the rate of return per $100.00 US Dollars (USD) of investment. For example, if the dollar duration associated with a given bond issue is 7.50 USD, then a change of one percent in the yield of the bond would amount to $7.50 USD. Keeping this in mind, the investor can evaluate the relationship between the yield and the price and determine if the investment is functioning according to projections. If it is not, the investor can make a decision of whether to hold on to the bond issue or to sell it and invest the funds into a different security option.
It is important to note that a number of factors can influence the performance of the bond. This in turn means that the margin for error associated with the calculation of a dollar duration can also fluctuate, depending on the factors involved. Such factors as the variance within the coupon as well as the amount of time to maturity may exert some degree of influence. A combination of these two factors may in turn impact the convexity or the second derivative associated with the investment.