Basis Point: Meaning, Value, and Uses

What Is a Basis Point (BPS)?

A basis point (BPS) is used to indicate changes in the interest rates of a financial instrument. Basis points are typically expressed with the abbreviations "bp," "bps," or "bips." One basis point is equal to 1/100th of 1%, or 0.01%. In decimal form, one basis point appears as 0.0001 (0.01/100).

Understanding Basis Points (BPS)

The word basis in the term basis point comes from the base move between two percentages, or the spread between two interest rates. Since 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 terms of basis points.

For example, it could be said that the interest rate offered by your bank is 50 basis points higher than the Secured Overnight Financing Rate (SOFR). A bond whose yield increases from 5% to 5.5% is said to increase by 50 basis points. Interest rates that have risen by 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 25 basis points, the new interest rate would be 2.75%.

Special Considerations

By using basis points in the conversation, traders and analysts remove some of the ambiguity or confusion that can arise when talking about 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 the financial instrument is now 11% (0.10 x (1 + 0.10), or it could mean that it is now 20% (10% + 10% = 20%).

The use of basis points, in this case, makes the meaning clear. If the instrument is priced at a 10% rate of interest and experiences a 100 bp move up, its rate would then be 11%. If the instrument experiences a 1,000 bp move up, it would be 20%.

Price Value of a Basis Point

The price value of a basis point (PVBP) is a measure of the change in the absolute value of the price of a bond for a one basis point change in yield. This may also be referred to as DV01, or the dollar value change for a one bp move. It is another way to measure interest rate risk and is 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 one 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.

Basis Points and Investments

Basis points are also used when referring to the cost of mutual funds and exchange-traded funds (ETFs). For example, a mutual fund's annual management expense ratio (MER) of 0.15% will be quoted as 15 bps.

When funds are compared, basis points are used to provide a clearer understanding of the difference in their costs. For example, an analyst may state that a fund with 0.35% in expenses is 10 basis points lower in cost 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.

Basis Points and Credit Spreads

Credit spreads are typically expressed in basis points, where one basis point is equal to 0.01%. For instance, if a corporate bond yields 3% and a comparable government bond yields 2%, the credit spread is 100 basis points (3% - 2% = 1% or 100 basis points).

The precision of basis points allows for clear communication of even small changes in credit spreads, which is crucial for accurate market assessments.

The credit spread, measured in basis points, reflects the perceived credit risk of the bond issuer. A wider spread indicates higher credit risk and vice versa.

For example, if the credit spread of a company's bond widens from 100 basis points to 150 basis points, it suggests that investors perceive an increase in the company's credit risk. This change in perception can be due to various factors including the deteriorating financial health of the issuer or unfavorable market conditions.

Changes in credit spreads, therefore, measured in basis points, impact bond prices inversely. When credit spreads widen and there's an increase in basis points, bond prices generally fall because investors demand higher yields to compensate for the increased risk.

Conversely, when credit spreads narrow (a decrease in basis points), bond prices typically rise as the perceived risk decreases and investors are willing to accept lower yields.

Basis Points and Risk Management

Basis points can also generally be used as part of risk management techniques. Though some of the following points may seem intuitive after reading the article above, it's a worthwhile callout to note that small changes in basis points can tell more information than just a change in percent.

Basis points offer a high level of precision. This precision allows for accurate measurement and communication of even the smallest changes in financial variables. For instance, when discussing interest rate changes or credit spread variations, even a slight deviation in either direction can give vital information about broader markets.

As we talked about in the last section about credit spreads, a widening of credit spreads indicates an increased perceived risk of default.

Therefore, it may not even matter the number of basis points; for risk management, the key part is understanding the direction in which basis points are aggregating. Risk managers use basis points to monitor these spreads and adjust their credit exposure accordingly.

Market risk, or the risk of losses due to changes in market conditions, can also be assessed using basis points. Fluctuations in market variables such as equity prices, foreign exchange rates, and commodity prices can be measured in basis points.

Therefore, users of this information can use basis points to evaluate how volatile these items may be (and the direction in which they're moving).

Last, in stress testing and scenario analysis, risk managers use basis points to model the impact of extreme but plausible changes in market conditions.

For example, they might analyze the effect of an interest rate increase of 200 basis points on the portfolio’s value. They then can refine that model to as fine of a level as they want (i.e. they can adjust to 201 basis points to see how that minute change can impact models).

The Bottom Line

Basis points are a common unit of measurement in finance. A basis point is 1/100th of 1% and is commonly used to indicate interest rates or changes in rates in bonds and other financial instruments.