Basis Point - Explained
What is a Basis Point?
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Table of ContentsWhat is a Basis Point?How Does a Basis Point Work?Academics Research on Basis Point (BPS)
What is a Basis Point?
Basis point (BPS) is a commonly used unit for measuring interest rates as well as other percentages used in the finance sector. One basis point tells how much percentage change a financial instrument has experienced. It is equivalent to 0.01% or 0.0001, and is calculated by taking 1/100th of 1%. There is a link between the change in percentage and basis points, where a change of 1% translates to 100 basis points, and that of 0.01% translates to 1 basis point.The word basis in the term refers to the base movement taking place between two percentages. It can also be referred to as spread occurring between two rates of interest. Since the fluctuations are not too huge, and these little fluctuations can have huge results, the basis becomes a fraction of 1%.
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How is a Basis Point Used?
The basis point is usually considered for ascertaining fluctuations in interest rates, equity-based indices, and the returns offered by a fixed-income instrument. Both bonds and loans usually receive quotes in the form of basis point. For instance, you may say that your bank offers interest rate that is 50 basis points more than LIBOR or London Interbank Offered Rate. When the yield of a bond rises from 5% to 5.5%, it means that it has increased by 50 basis points, and when the rate of interest increases by 1%, it is considered to be risen by 100 basis points. Target interest rate, when raised by the Federal Reserve Board, by 25 basis points, it refers to the increase in interest rates by 0.25%. In case, the Fed increases the interest rate from 2.50% to 2.75%, it means that there has been an increase of 25 basis points. Basis points make it easier for people including traders, and financial analysts to understand the essence of changes in percentage. For instance, a financial instrument that carries a 10% rate of interest, and has a 10% increase ahead, it could either give a perception that the new rate is 11% (10% + 10% of 10), or 20% (10% + 10%). Here, the above statement gave vague information. However, by using the concept of basis point, it gets pretty obvious to ascertain that if the rate of interest of an instrument is 10%, and it experiences an upward movement of 100 basis points, then it is 11% now. Had the basis points increased by 1000, it would have resulted in 20%. The price value of a basis point (PVBP) ascertains the absolute value of the bonds price change with respect to the change in one basis point in yield. This also helps in ascertaining risks associated with interest rates, just like the duration that determines how much a bond price changes if there is a 1% change made in the interest rates. PVBP tends to be a unique case for dollar duration. Here, the price value of a basis point considers using a 1 basis point change rather than 100 basis points. Whether the rates are going up or down, it holds no relevance as this tiny movement in rates will almost be the same in any of the directions. It can also be known as dollar value change for a 1 bp move or DV01. Analysts use basis points at the time of ascertaining the costs associated with mutual funds and exchange-traded funds. If a mutual fund bears an annual management expense ratio of 0.10%, it will receive a quote of having 15bps. At the time of comparing one fund with another, basis points enables to give a clear picture of variations in the costs of investment funds. For instance, a financial analyst can say that a mutual fund having 0.45% as annual expenses is 10 basis points more than the one having annual costs of 0.35%. As interest rates are not applicable on equity, basis points are not significantly used for quoting prices in the stock market.