What is the definition of a Basis Point (BPS) in finance?
A basis point is a unit of measurement equals to .01 or 1/100th of 1% (1 percent). According to its calculation 1 BPS equals 0.01%, 10 BPS equals 0.1%, 50 BPS equals 0.5%, 100 BPS equals 1%, 1000 BPS equals 10%, and 10000 equals 100%. The BPS is used in the measurement of fixed-income yields, interest rates, and other financial rates. It is the most used metric for bonds and loans to indicate yield spreads or percentage changes in different financial instruments.
Why Basis Points (BPS)?
The use of BPS is primarily assigned to interests and yields, however, they can also be used in calculating the change in the value of assets such as treasury bonds, corporate bonds, stock values, credit derivatives, interest rate derivatives, options, futures, and mortgage loans.
Investors and analysts use BPS as a metric for measuring interest rates. Other measures can be used as well, however, the BPS has a few distinctions that make investors and analysts consider it alongside other financial measuring tools. A BPS can be used to:
Easily, comprehensively, and relatively discuss absolute interest rates especially when dealing with a rate difference less than 1 percent and the amount of material worthy of discussion. Such that, if a company experiences a 1% increase of a 12% to 13% interest increase rather than outrightly state that there is a 1% increase, using the absolute method, or stating that there has been a 9.09% increase using the relative method the BPS would help put away the confusion. It can be simply stated that the interest rate has increased by 100 basis points. (i.e. 100 basis points equals 1%).
Define all increased interest rate changes that reflect during the reporting of securities and interest rates.
Calculating Basis Points
The “basis” in BPS is derived from the spread between two interest rates or the difference between two percentages. The basis usually occurs as a fraction of a percent because small changes can have large results. The table below reflects the basis points and percentage outcomes.
As earlier stated, BPS is primarily applied to interest and yields but can be used in the calculation of the changes in securities. Usually, loans and bonds are quoted in basis points terms such that the interest rate offered by a said bank can be higher than the London Interbank Offered Rate (LIBOR) by 10 basis points. For example, if the Federal Reserve Board decides to raise the interest rate by 0.35% it will imply that there has been an interest rate increase of 35 basis points. Or a bond yield increases from 2% to 3% it would imply that there has been a 1% interest rate increase, thus, 100 basis points interest increment.