What is a basis point?
What is a basis point and why you should care?
So what is basis point anyway? Basis points refer 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%, 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. The basis point is commonly used for calculating changes in interest rates, equity indexes and the yield of a fixed-income security. It is common for bonds and loans to be quoted in basis point terms.
It could be said that the interest rate offered by your bank is 50 basis points higher than 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. Or, 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%. By using basis points in conversation, traders and analysts remove some of the ambiguity that can arise when talking about things in percentage moves. If a financial instrument is priced at a 10% rate of interest and the rate experiences an increase of 10%, it could conceivably mean that it is now 10% x = 11% OR it could also mean 10% 10% = 20%. The intent of the statement is unclear. 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 1,000 bp move. The Price Value of a Basis Point is a measure of the absolute value of the change in 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. 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. 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. We hope this helps you understand “What is a basis point?“