Basis Points Definition
Basis points (bps) in finance is the smallest unit to measure return on bonds, note, other fixed income securities, and interest rate quotes. A basis point is also used to show a minor percentage change in interest rate, the yield of bonds, etc.
From the viewpoint of investors, traders, and analysts, 1 BPS is equal to a variation of 0.01%, and 100 BPS is equal to a variation of 1 percent.
In the financial market, the use of BPS is preferred over a percentage to avoid any confusion. For e.g., if an analyst states that an instrument that was yielding 15% of the rate of interest and there is an increase of 10% in rate. As an investor, there will be confusion whether this 10% increase in the rate is absolute that means 15% + 10%= 25% or relative 15%(1+10%)= 16.5%.
The use of BPS avoids such ambiguity. If an instrument that was yielding 15% of the rate of interest and there is an increase of 50 BPS, this clearly means the new rate of interest is 15% +0.5%= 15.5%.
Understanding of BPS
The following are some points to understand basis points (bps) in finance better.
#1 – For Inter-Bank Lending Rate
In the newspaper, we generally read the news like the Federal Open Market Committee has lowered its benchmark fund rate by 25 basis points. This means that now the bank will cut the overnight lending charge to other banks by 0.25 %.
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#2 – For Mutual Funds
As an investor, when we look for mutual fund and exchange-traded funds, we look into a very important parameter called Expense Ratio – which is a kind of annual fee which is deducted by the fund manager from the asset. Generally, the expense ratio is measured in BPS as if the expense ratio is 175 BPS, and then the fund manager will deduct 1.75% of the total asset as fund expense every year.
#3 – For loans
When we hear news like a bank has reduced the home loan lending rate by ten basis points, then this states that now Home loan has become cheaper by 0.1 %.
BPS also used to measure whether banks are passing the benefits of the rate cuts by the central bank to the consumers or not. Like if the Federal Open Market Committee (FOMC) cut the rate, then the bank should also reduce the prime lending rate, and the interest rate on loans should come down. If rates are not coming down, then the banks are not passing the benefit of the rate cut to consumers, So the consumer can switch their loan to other banks with lower interest rates.
#4 – For Change in Yield on Bond
Suppose Adams has invested $10,000 in a bond that usually yields an interest of 4%. A year later, rates have dropped by 100 basis points (reduced by 1%), which means now the same bond after a year yields 3%. So the value of bond purchase a year back yields a higher return that is $400 as compared to the same bond purchased after a year that yields are $300.
#5 – For Calculation of Floating Interest Rate
The yield of some of the bonds are linked to some other offer rates and are not fixed. For e.g., the interest rate of some of the bonds are linked to the London Interbank Offer Rate (LIBOR) like “30 basis point above LIBOR”, so if LIBOR is 2.5%, then the Interest rate on the bond will be 2.5% + 0.3% = 2.8%
Calculation of Basis Point in Finance
Below are the examples to explain bps calculation.
Example #1
A Bank has cutdown Home loan lending rate by 25 basis point from 8.75%, so in this case, the new lending rate will be as follows:
Given:
- Previous Lending Rate: 8.75%
- Rate Cut (in BP): 25
- 1 BP(Basis Point): 0.01%
So, Rate Cut in percentage will be –
- Rate Cut = 0.01%*25
- Rate Cut = 0.25%
New Lending Rate will be –
- New Lending Rate = 8.75% – 0.25%
- New Lending Rate = 8.50 %.
Example #2
Adams purchased a short term fund that gave a return of 10% in a year on which the expense ratio is quoted as a 25 basis point. So, in this case, the net return on investment will be:
- Return from Fund = 10%
- Expense Ratio = 25 BPS = 25*0.01%= 0.25%
- Net Return from Fund= 10% -0.25% = 9.75%
Basis Point Value Calculation
Basis point value also is known as DV01, represents the change in the value of the asset when the yield on asset change by 1 BPS. Instead of using a basis point change, the price value of a one basis point is used to represent changes.
For Example, there is a Eurodollar future contract with the face value of is $100000 that tracks 3 months LIBOR. So its BPV will be:
So,
- BPV = $100000 x (90 ÷ 360) x 0.0001
- BPV = $ 25
(1 BP = 0.01%= 0.0001)
Advantages of Basis Point
Some of the advantages of BPS are as follows –
- Clarity – The main importance of Basis Point is that it brings clarity while discussing the changes in interest rates or other financial parameters. Unlike in percentage where change denoted in percentage always confuse the stakeholders whether the change is absolute or relative one.
- In Explaining Spread – A basis point is most commonly used in the financial world to explain the ‘Spread.’ Spread generally refers to a change in the price of an asset after a time duration or change in the return on a percentage. So, if Spread is expressed in terms of Basis Point, then it will represent a clear picture of variation.
Conclusion
Basis Points (BPS) is the smallest unit of measuring yield on the bond, note, and other fixed-income Security. One basis point is equal to 1/100 of one percentage point or 0.01. BPS is commonly used by the stakeholders in the financial market because it brings clarity to the discussion.
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