Basis points (BPS) is the most common unit of measurement for interest rates and other percentages. The term is used most often in the context of financial markets, but the concept can be applied to any system of measuring.
The term is a contraction of “basis point”, sometimes it is also used as “bips” and comes from the fact that one basis point is equal to one-hundredth of one percent. The fractional part of one basis point is sometimes referred to as the “fractional part of a percent.”
For example, if we say that the interest rate has changed from 6% to 7%, then this change denotes an increase of 100 basis points. From here we can understand that a 1% change in interest rates equals 100 basis points. If we simplify this further, it can be seen that 1 basis point can also be written as 0.01%.
Let us look at this table for further clarity.
The Need for Basis Point System
The term basis points are used extensively in finance and economics but outside of this sphere, it is hardly used at all. This term developed over time to refer to changes in interest rates in the economy and on various investment instruments.
It is not known who originated this term but what is known is that it arose as a way to simplify how economists talk about rate changes. For instance, if the interest rate changes from 10% to 11%, then one way of saying this is that the rate has increased by 1% to 11%. However, we can also say that the base interest rate of 10% has been increased by a further 10%. This would also be correct. How?
Let us see. The base interest rate is 10%. If we say that the rate has increased by 10%, then we mean that 10 x 110/100 = 1%, hence 10% + 1% = 11%
But you can now see that this is confusing because someone can also understand a 10% increase as 10% + 10% = 20%
So using percentage, to explain changes in interest rate is confusing and it leaves room for error. This is why the basic system developed because it brings clarity to interest rate changes.
Let us look at the above example again.
We can see that the base rate is 10% and it has been changed to 11%. Using the basic system we can simply say that the base interest rate has been increased by 100 basis points. This is a clear and unambiguous system, which leaves no room for confusion and error.
Basis points are commonly used in financial instruments to measure changes in a rate, as in the case of changes in the federal funds rate. The federal funds rate, or the rate at which banks lend reserves to each other, is commonly calculated by taking the average of a number of key short-term interest rates, such as the Federal Funds Rate, the London Interbank Offered Rate (LIBOR), the Euro Interbank Offered Rate (EURIBOR), and the U.S. Treasury Bill rate.
The basis point is used to measure the change in this rate over time, as the rate changes from one time period to another. For example, a 0.25 basis point change in the federal funds rate would mean that the rate had increased by 0.25 percentage points or 0.25%.
The term is also used in various other areas, such as the trading of interest rate swaps.
The term is also used in the foreign exchange market. For example, one basis point is equal to 0.01% of the difference between the bid and the asking rate.
Basis points are also used to measure changes in a currency, such as the U.S. dollar. One basis point equals 0.01% of the difference between the exchange rate and the official exchange rate. In the foreign exchange market, one basis point equals 0.01% of the difference between the bid and the asking rate.
The basis points are also used in mutual funds, where they have a specified usage. Mutual funds are analyzed based on certain KPIs and one important KPI for investors is the management expense ratio or MER.
A mutual fund for instance can have an MER of 0.15% and this can be said as an MER of 15 bps. Similarly, if another mutual fund has an MER of 0.25%, then someone comparing these two mutual funds would say that the second mutual fund was 10 bps higher than the first one. This provides a clear understanding of the cost of investing in mutual funds.
Basis points are therefore most commonly used in instances where interest rates apply. Stocks do not deal with interest rates, which is why basis points are not used that much in equity markets.
In conclusion, it can be said that basis points are a clear and easy way to express the changes in the interest rate or the spread between two rates.