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For Example:

Assume you purchase $1,000 of a bond fund. If the bond fund has an average duration of 5 years and general interest rates increase 1% , what is the impact on the value of the bond. What would you expect the $1,000 to be worth?

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When interest rates go up, the prices of fixed-rate bonds go down (since you can now get bonds with higher coupon rates). So the value of a bond fund would go down.

Duration is a measure of the sensitivity of bond prices to interest rates. Mathematically, the relative change in value is approximately equal to the duration times the change in interest rates, or

dV/V ~= D * -dY

source

So a fund with an average duration of 5 years would go down about 5% (to about $950) if interest rates increased 1%.

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  • Thank you so much for the answer. Could you explain the math behind that for me? Just trying to understand fully. – M Pearson Apr 15 at 15:28
  • dV = V * D * dY (from here) , so 1,000 * 5 * -.01 = -50 – D Stanley Apr 15 at 15:32
  • D Stanley, I interpret the original post as saying "if general interest rates increase by 100 bps." Is that what you are responding to? Or is your response to the question of when general interest rates increase by a factor of .01? – Orange Coast- reinstate Monica Apr 15 at 17:40
  • Yes the formula for duration uses the actual change in interest rates (e.g. from 2% to 3%), not a relative change (e.g. from 2.00% to 2.02%). – D Stanley Apr 15 at 19:36

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