DV01 stands for the dollar value of a basis point, and it is a very widely used measure of interest rate risk in fixed income markets.

It's not only used for bonds, but also for derivatives like interest rate swaps.

So how does it work? Essentially, DV01 tells us the actual profit and loss impact of a one basis point change in yields.

A basis point is 100th of a percent, so 0.01% compared to modified duration.

DV01 has a couple of advantages.

First, it shows us how much money we stand to lose or gain on a specific position if yields move by a certain amount.

While modified duration gives the relative sensitivity of a bond DV01 factors in both the bond's sensitivity and the size of the position, the larger the position, the larger the monetary impact of a given change in yields.

Second, DV01 focuses on a one basis point change in yields, which is generally more realistic over shorter timeframes compared to a 1% move for most currencies and bond markets.

A one basis point change is much more practical to work with in the near term.

So DV01 is a very useful ratio, and the good news is that for a single bond position, we can calculate it by just slightly modifying the calculations For modified duration, let's break it down.

First, we have to multiply the modified duration by 0.01%, not by the 1% used for modified duration.

Second, we calculate the absolute price change by multiplying the result with a current bond price.

This gives us the actual dollar change in the bonds price for a one basis point move in yield.

Finally, we multiply the absolute change in bond price by the position size to get the actual profit and loss impact in dollar terms, and that's it.

DV01 helps bond holders and risk managers see exactly how a small movement in interest rates affects their bottom line, and that's why it's such a commonly used tool.

Let's apply this to an example bond and see what the DV01 tells us.

We'll use a five-year, 2.4% coupon bond with a current yield to maturity of 2.43%, giving a current bond price of 99.8603%.

This bond has a modified duration of 4.6577.

To calculate DV01, we take the negative of the modified duration To account for the inverse relationship between yields and price, which we multiply by 0.01% or one basis point then by the current bond price, 99.8603%, and finally, by the assumed position size of 100 million face value, the result is negative 46511.8.

This means that if yields were to increase by one basis point, so from 2.43% to 2.44%, a long position of 100 million in face value would lose approximately 46,511 in market value.

To get a sense of the impact of a larger change in yields such as a 10 basis point move, you can simply multiply the DV01 by 10.

However, it's important to remember that when we doing this, we are assuming a linear relationship between bond prices and yields.

This introduces some prediction error because the bond price yield relationship is actually convex, not linear.

So while this scaling gives you a rough estimate, the actual change in bond price will differ slightly due to the effect of convexity.