Basis Point

A basis point (bps) is a unit of measure used in finance to describe the smallest movement in interest rates, bond yields, and other percentages in financial markets. One basis point is equal to one-hundredth of a percentage point, or 0.01%. This precise measurement is crucial for understanding changes in financial metrics that can have significant implications.

Why are basis points important?

Basis points are important for several reasons:

• Precision: They provide a precise way to describe small changes in interest rates and yields, which can be significant in financial contexts.
• Clarity: Using basis points helps avoid confusion, especially when discussing percentage changes. For example, saying an interest rate increased by 1% could mean different things, but saying it increased by 100 basis points is clear and specific.
• Standardisation: Basis points are a standard unit of measure in finance, making it easier to compare changes across different financial instruments and markets.

How basis points are used

Interest rates

Basis points are commonly used to describe changes in interest rates. For example, if the Reserve Bank of Australia (RBA) raises the cash rate by 25 basis points, it means the rate has increased by 0.25%.

Bond yields

In the bond market, basis points are used to measure changes in bond yields. A movement of 10 basis points in a bond yield represents a 0.10% change. This precision is crucial for bond investors, as small changes in yields can significantly affect bond prices and returns.

Credit spreads

Credit spreads, which represent the difference in yield between two securities, are often measured in basis points. For instance, if the spread between a corporate bond and a government bond widens by 50 basis points, it means the difference in their yields has increased by 0.50%.

Fees and expenses

Basis points are also used to describe fees and expenses in the financial industry. For example, a mutual fund may charge an annual management fee of 100 basis points, equivalent to 1% of the invested assets.

Calculating basis points

Converting basis points to percentage

To convert basis points to a percentage, divide the number of basis points by 100. For example:

• 50 basis points = 50 / 100 = 0.50%
• 125 basis points = 125 / 100 = 1.25%

Converting percentage to basis points

To convert a percentage to basis points, multiply the percentage by 100. For example:

• 0.75% = 0.75 * 100 = 75 basis points
• 2.10% = 2.10 * 100 = 210 basis points

Examples of basis points in practice

Central bank interest rate changes

When the RBA adjusts the cash rate, the change is often expressed in basis points. If the RBA lowers the cash rate from 1.50% to 1.25%, this 0.25% decrease can be described as a reduction of 25 basis points.

Bond market movements

An investor holds a government bond with a yield of 2.00%. If the yield increases to 2.15%, the yield has risen by 15 basis points. This change may seem small, but it can significantly impact the bond’s price and the investor’s return.

Mutual fund fees

A mutual fund charges an annual management fee of 0.75%. This fee can also be described as 75 basis points. If the fund increases the fee to 0.85%, this represents an increase of 10 basis points.

Example of illustrating basis points

Consider a scenario where a homeowner has a mortgage with an interest rate of 4.00%. If the bank offers to refinance the mortgage at a rate of 3.75%, the difference of 0.25% is equivalent to 25 basis points. This reduction in the interest rate can lead to substantial savings over the life of the mortgage.

Conclusion

Basis points are a fundamental unit of measure in finance, providing a precise and clear way to describe small changes in interest rates, bond yields, and other financial metrics. Understanding basis points is crucial for anyone involved in financial markets, as these small movements can have significant implications for investments, borrowing costs, and overall financial planning.

For more detailed information on basis points and their application in various financial contexts, you can visit the Australian Securities and Investments Commission (ASIC) website.