You will find no shortage of measuring units in finances. Among these recurring terms is one called ‘basis point.’ This article will explain what it is while also periodically branching out to explain other similar units of measurement.
What does it mean?
‘Basis point’ is a term referring to a common measuring unit for interest rates. It additionally works for other percentages in finance. Abbreviations for it include ‘bp’, ‘bps’, and ‘bips.’
A singular basis point is equal to 1/100th of 1%, alternatively 0.01% or 0.0001. It is typically used to designate the percentage change within a financial instrument. The general relationship between percentage alterations and basis points can be summed up as the following:
1 basis point = 0.01%
5 basis points = 0.05%
10 basis points = 0.1%
50 basis points = 0.5%
100 basis points = 1%
1,000 basis points = 10%
10,000 basis points = 100%
A more detailed look
The titular “basis” derives from the base movement between two percentages. This is otherwise referred to as the spread between two interest rates. Due to the recorded changes usually being narrow, and also because small changes can have oversized outcomes, the “basis” is a fraction of a percent.
The average basis point is useful for calculating revisions in interest rates. Moreover, it calculates changes in equity indices and the yield of a ‘fixed-income security.’ This is an investment that supplies a return in the form of fixed periodic interest payments and the consequent return of principal at maturity. Unlike ‘variable-income securities’, in which payments change going off of underlying measures – such as short-term interest rates – the payments of a fixed-income security are acknowledged in advance.
Yields & Increases
It is not out of the ordinary for bonds and loans to be quoted in basis point terms. For instance, it is possible that the interest rate that your bank offers you is about 50 basis points higher than LIBOR (London Interbank Offered Rate). A bond whose yield increases from 5% to 5.5% is said to expand by 50 basis points. Moreover, interest rates that have gone up to 1% are said to have grown by 100 basis points.
If the FRB (Federal Reserve Board) raises the target interest rate by about 25 basis points, it means that rates have gone up by 0.25% percentage points. If the rates were at 2.50%, and the FRB boost them by 0.25% (or 25 basis points), the new interest rate would be 2.75%.
By utilizing basis points in a conversation, traders and analysts remove a portion of the uncertainty that can come from discussing things in percentage moves. For example, if a financial instrument has a price of a 10% rate of interest and the rate experiences a 10% increase, it could potentially mean that it’s now 0.10 x (1 + 0.10) = 11%. It could also suggest that 10% + 10% = 20%.
The intent of this statement is pretty unclear. The use of basis points in this particular case makes the meaning much more obvious. Let’s say the instrument has a price of a 10% rate of interest and experiences a 100 bp move up. It effectively becomes 11%. The 20% result would later occur only if there was instead a change of 1,000 bps.
The Price Value of a Basis Point (PVBP) is typically defined as a measure of the absolute value of the alteration in the price of a bond for a one basis point change in yield. It is also a useful tool to measure interest-rate risk. This is similar to duration, which measures the percent change in a bond price given a 1% change rate.
PVBP is also a common reference as the value of a basis point, dollar value of a basis point, or basis point value. It is a method of measuring the price sensitivity of a bond. How you go about settling this is quite straightforward. You access the change in the price of a bond if the required yield modifies by one basis point.
PVBP is a special case of ‘dollar duration’. This term is indicative of the measurement of the dollar change in a bond’s value to an alteration in the market interest rate. A dollar duration is a common tool of use by professional bond fund managers. They use it as a way of approximating the portfolio’s interest rate risk.
Anyhow, rather than using a 100 basis point change, the price value of a basis point will just use a 1 basis point revision. Ultimately, it does not matter if there is an increase or decrease in rates. This is because the tiniest move in rates will be about the same in either direction. This is also something people will usually refer to as DV01 or the change in dollar value for a 1 bp move.
Basis points are also incredibly useful when it comes to referring to the cost of mutual funds and exchange-traded funds (ETFs). A mutual fund in possession of an annual management expense ratio (MER) of about 0.15% will be quoted as having 15 bps. The MER – sometimes ‘expense ratio’ (ER) – is another unit of measurement. It measures how much of the assets of a fund are put into use for administrative and other operating expenses. There is a way to determine the expense ratio. This is done by dividing a fund’s operating expenses by the average dollar value of its assets under management (AUM). Operating expenses will reduce the fund’s assets, thereby reducing the total return to investors.
If one were to compare funds, basis points would then provide a much clearer understanding of the difference between the cost of investment funds. For instance, an analyst may potentially state that a fund with 0.35% in expenses is 10 bps less than another with an annual expense of 0.45%.
Interest rates do not apply to equity. Because of this, basis points are not as useful in terminology for price quotes in the stock market.
On the surface, it is relatively simple to define a basis point. However, by digging a little deeper, you will find that there is more to it than a basic conversion of points to percentage.