That sounds like the name of a bar owned by Wall Street traders. As nearly a thousand of us prepare to head to Times Square for the MBA’s National Secondary conference, it’s time for a refresher on the noble basis point for those going to the event who aren’t actually in capital markets.
It’s simple: A basis point, pronounced “bip” and also termed as bps, is one hundredth of 1 percentage point. Changes in interest rates are often stated in basis points, so the financial press and people watching the bond market will use this measure. For example, if an existing interest rate of 5 percent is increased by 1 basis point, the new interest rate would be 5.01 percent.
Put another way, bps are a unit of measure used in finance to describe the percentage change in the value of financial instruments or the rate change in an index or other benchmark. One basis point is equivalent to 0.01% (1/100th of a percent) or 0.0001 in decimal form. If the Fed’s Federal Open Market Committee (FOMC) increased the benchmark interest rate by 25 basis points, or 0.25 percentage points, to a range of 5 percent to 5.25 percent.
In the bond market, basis points are used when referring to the yields that fixed-income instruments pay investors. For example, if a bond yield spikes from 4.45 to 4.65 percent, it is said to have risen 20 basis points.
Why even use bps? To eliminate ambiguity. “The bond’s yield was 10% before rising 5%.” This expression may be interpreted in two entirely different ways. In one scenario, the 5% increase is absolute, in which case the new yield is 15%. Alternatively, the increase could have been relative, where 5% of 10% is 0.5%. In this scenario, the new yield would be 10.5%. What’s right? Since one basis point is always equal to 1/100th of 1%, or 0.01%, basis points can eliminate the ambiguity demonstrated by the example above and create a universal measurement that can be applied to the yields of any bond. The increase from 10% is either 50 basis points (which is 10.5%) or 500 basis points (which is 15%).