Final answer:
The dollar duration of a fixed-income security measures the change in the bond's market price in response to a one-percent change in interest rates. As interest rates rise, the present value and market price of the bond decrease even though the actual dollar payments it offers do not change.
Step-by-step explanation:
The dollar duration of a fixed-income security is best defined as the dollar value change in the price of a security for a given change in yield. Specifically, it is often described as the dollar value change in the price of a security to a one-percent change in the yield to maturity of the security. When interest rates change, the present value of the bond's future cash flows will also change causing the market price of the bond to adjust accordingly.
For example, if a bond with a face value of $1,000 has an 8% coupon rate and is initially aligned with market interest rates, it would be expected to sell at its face value. However, if market interest rates increase to 11%, the present value of its future cash flows would be discounted at this new higher rate, resulting in a lower market price for the bond. This occurs even though the bond's actual dollar payments, determined by its initial 8% interest rate, do not change.
Rising interest rates make new bonds with higher coupons more attractive, leading to a decrease in the value of existing bonds with lower coupons. This change in market price is what the dollar duration measures, indicating the sensitivity of a bond's price to changes in interest rates.