Basis Point

Definition

A basis point (bps) is a unit of measurement used in finance to describe the percentage change in the value or rate of a financial instrument. One basis point is equal to 0.01% or 0.0001, and is commonly used to quantify changes in interest rates, bond yields, and other financial metrics.

5 Must Know Facts For Your Next Test

1. Basis points are commonly used to express small changes in interest rates, as it provides a more precise measurement than percentage points.
2. A change of 100 basis points is equivalent to a 1 percentage point change (e.g., from 5% to 6%).
3. Basis points are used to track the performance of fixed-income investments, such as bonds, where small changes in yield can have a significant impact on the value of the investment.
4. Central banks often adjust interest rates in increments of 25 or 50 basis points to influence economic conditions and control inflation.
5. Basis points are also used to measure the spread or difference between two interest rates, such as the spread between a corporate bond yield and a government bond yield.

Review Questions

• Explain how basis points are used to measure changes in interest rates.
  • Basis points are a common unit of measurement used in finance to express small changes in interest rates. One basis point is equal to 0.01% or 0.0001, which allows for more precise tracking of changes in interest rates compared to using percentage points. For example, a change in interest rates from 5% to 5.25% would be a 25 basis point increase. Basis points are particularly useful when analyzing the performance of fixed-income investments, such as bonds, where small changes in yield can have a significant impact on the value of the investment.
• Describe the relationship between basis points and percentage points when discussing changes in financial metrics.
  • Basis points and percentage points are related, but distinct, units of measurement used in finance. A change of 100 basis points is equivalent to a 1 percentage point change. For example, if an interest rate increases from 5% to 6%, this would be a 100 basis point increase or a 1 percentage point increase. Basis points provide a more granular way to measure small changes in financial metrics, such as interest rates and bond yields, which is important for tracking the performance of fixed-income investments and analyzing the decisions of central banks and other financial institutions.
• Analyze the significance of basis points in the context of the relationship between interest rates and bond yields.
  • Basis points play a crucial role in understanding the relationship between interest rates and bond yields. Small changes in interest rates, often measured in basis points, can have a significant impact on the yield of bonds. This is because bond prices and yields move inversely, so a decrease in interest rates will lead to an increase in bond prices and a decrease in yields, and vice versa. Investors closely monitor changes in basis points to assess the performance of their fixed-income investments and to anticipate the potential impact of interest rate changes on the bond market. Understanding the significance of basis points is essential for making informed decisions in the fixed-income market.

Related terms

Interest Rate: The rate at which interest is paid by a borrower for the use of money borrowed from a lender.

Yield: The return earned on a bond or other fixed-income investment, typically expressed as a percentage.

Bond: A debt security issued by a government or corporation, representing a loan that must be repaid with interest.