Definition
The term basis point refers to a unit of measure equal to one one-hundredth of one percent. Basis points are a common unit of measure in the financial and investing fields of work.
Calculation
Basis Point = 1 / 100%, or 0.01%
Explanation
Oftentimes a change in a security is stated in terms of basis points, or BPS. A basis point is equal to 0.01%; stated another way, there are 100 basis points in 1%. Basis points are frequently used when discussing a change in interest rates. For example, it is more common to report the change in interest rates on a bond quoted as 25 basis points, than 0.25%
Stating a change in terms of basis points eliminates the possibility of confusion as to the exact movement of an interest rate. For example, there are two possible interpretations of the below statement:
A security paying a 5% rate of interest will increase by 1%
The above statement could mean the security will pay a 5% + 1%, or 6% rate of interest. The above statement could also mean the security will pay a 5% + 1% of 5%, or 5.05% rate of interest. If the statement used basis points, the ambiguity is removed. For example, there is only one possible interpretation of the below statement:
A security paying a 5% rate of interest will increase by 5 bps
It is now clear the security will pay a rate of interest equal to 5.05%.
Related Terms
The term basis refers to the total cost of a security, including commissions, expenses, and fees. Basis can also refer to the difference between the spot price of a commodity and its futures price, as well as the after-tax balance of an IRA.
Moneyzine EditorNovember 6th, 2024
The term basis trading refers to an arbitrage strategy used by investors to profit from the mispricing of two related securities. The arbitrager believes that as the mispricing of the securities experience a correction over time, there will be a gain on one side of the trade that will more than offset the loss on the other side of the trade.Moneyzine EditorNovember 6th, 2024
