Basis points (BPS) refers to a common unit of measure for interest rates and other percentages in finance. One basis point is equal to 1/100th of 1%, or 0.01%, or 0.0001, and is used to denote the percentage change in a financial instrument. The relationship between percentage changes and basis points can be summarized as follows: 1% change = 100 basis points and 0.01% = 1 basis point.
Basis points are typically expressed in the abbreviations “bp,” “bps,” or “bips.”
The “basis” in basis point comes from the base move between two percentages, or the spread between two interest rates.
The basis point is commonly used for calculating changes in interest rates, equity indices, and fixed-income security yields.
Basis points are also used when referring to the cost of mutual funds and exchange-traded funds.
Understanding Basis Points
The “basis” in basis point comes from the base move between two percentages, or the spread between two interest rates. Because the changes recorded are usually narrow, and because small changes can have outsized outcomes, the “basis” is a fraction of a percent.
The basis point is commonly used for calculating changes in interest rates, equity indices, and the yield of a fixed-income security. It is common for bonds and loans to be quoted in basis point terms. For example, it could be said that the interest rate offered by your bank is 50 basis points higher than the London Interbank Offered Rate (LIBOR). A bond whose yield increases from 5% to 5.5% is said to increase by 50 basis points, or interest rates that have risen 1% are said to have increased by 100 basis points. If the Federal Reserve Board raises the target interest rate by 25 basis points, it means that rates have risen by 0.25% percentage points. If rates were at 2.50%, and the Fed raised them by 0.25%, or 25 basis points, the new interest rate would be 2.75%.
Using basis points in conversation instead of talking in percentages instantly clarifies whether that “10% increase” in a financial instrument priced at 10% means that it’s now at 11% [0.10 x (1 + 0.10) = 11% ] or 20% [10% + 10% = 20%].
By using basis points in conversation, traders and analysts remove some of the ambiguity that can arise when talking about things in percentage moves. For example, if a financial instrument is priced at a 10% rate of interest and the rate experiences a 10% increase, it could conceivably mean that it is now 0.10 x (1 + 0.10) = 11% or it could also mean 10% + 10% = 20%.
The intent of the statement is unclear. The use of basis points, in this case, makes the meaning obvious: If the instrument is priced at a 10% rate of interest and experiences a 100 bp move up, it is now 11%. The 20% result would occur if there were instead a move of 1,000 bps.
The Price Value of a Basis Point (PVBP) is a measure of the absolute value of the change in the price of a bond for a one basis point change in yield. It is another way to measure interest-rate risk, similar to duration, which measures the percent change in a bond price given a 1% change in rates.
PVBP is just a special case of dollar duration. Instead of using a 100 basis point change, the price value of a basis point simply uses a 1 basis point change. It does not matter if there is an increase or decrease in rates because such a small move in rates will be about the same in either direction. This may also be referred to as DV01, or the dollar value change for a 1 bp move.
Basis points are also used when referring to the cost of mutual funds and exchange-traded funds (ETFs). A mutual fund with an annual management expense ratio (MER) of 0.15% will be quoted as having 15 bps. When funds are compared, basis points are used to provide a clearer understanding of the difference between the cost of investment funds. For example, an analyst may state that a fund with 0.35% in expenses is 10 basis points lower than another with an annual expense of 0.45%.
Since interest rates don’t apply to equities, basis points are less commonly used as terminology for price quotes in the stock market. Instead, stock prices are quoted in dollars and cents.
What Is a Basis Point?
“Basis point” is simply a term used in finance to refer to an increment of 0.01%. Put differently, the expressions “basis point”, “1/100th of 1%”, “0.01%”, and “0.0001” all have the same meaning. For example, 5 basis points would mean 0.05%. Likewise, if an interest rate increased from 5.00% to 5.25%, that would represent an upward move of 25 basis points.
Why Use Basis Points Versus Percentages?
The reason traders use the term basis point is that it can be more convenient than referring to the percentage and can also help avoid ambiguity. This can help expedite communications and avoid trading mistakes. Since the values of financial instruments are often highly sensitive to even small changes in underlying interest rates, ensuring clarity can be very important for traders.
Where Does the Term Basis Point Come From?
The origins of the term basis point come from the term “basis”, which refers to the difference (or “spread”) between two interest rates. Oftentimes, traders will refer to basis points when describing the change in one instrument relative to another, such as when comparing the yield on a corporate bond against the interest rate offered on Treasury securities. Basis points are also commonly used when comparing the management expense ratios (MERs) of competing investment products.