Like many other professionals, the world of finance and investing has a wide list of industry-specific lingo that can be difficult to decipher for everyday investors and traders.
One of the most common terms you will come across on Wall Street is “basis points,” which is an important unit of measurement used to describe and compare financial products.
It’s a good idea to learn about basis points because they are often associated with interest rates and can affect your stock portfolio and monthly mortgage payments.
In this guide, you’ll learn what basis points are, how they are used, how to convert percentages into basis points, and more.
Basis point definition
Investment professionals and market analysts regularly mention “basis points” when talking about things such as interest rates, U.S. Treasury bonds, exchange-traded funds, real estate-based investments, or mutual funds.
A single basis point is equal to 0.01 percent or 0.0001.
1 basis point = 0.01% (1/100 of a percent) = 0.0001 in decimal form
They are a commonly-used unit for measuring some financial instruments that are expressed as a percentage.
The following is a list of some of the instruments that are commonly measured using basis points:
- Interest rates
- Treasury bonds
- Corporate bonds
- Equity securities
- Debt securities
- Credit derivatives
- Futures and options
This seemingly tiny unit of measure is most commonly used when market analysts and finance professionals are discussing percentages, especially tiny percentage changes where the values to the right of the decimal point are significant.
Conversion between basis points and percentage
Now, let’s look at how to calculate basis points.
You can use simple arithmetic or a calculator to convert a percentage to basis points and, likewise, basis points to percentages.
The most important thing to keep in mind when calculating them is that a single point is equal to 0.01%, or 0.0001.
With that in mind, you can easily convert a percent into basis points by simply taking the percent (in decimal form) by 0.0001. So if the rate on a Treasury bond has increased by 1.35% simply take 0.0135% (1.35%/100) and divide by 0.0001 to get 135 basis points.
This can also be done in reverse to convert basis points into a percent by simply taking the number of points and multiplying by 0.0001, which will give the percent in decimal form.
For example, if you want to convert 122 basis points into a percent, simply multiply 122 by 0.0001. This will give you 0.0122, which is 1.22%.
So, if we say 50 basis points, we will mean 0.50 percent.
For example, if the U.S. Federal Reserve hikes its benchmark interest rate by 50 basis points, it means interest rates have increased by half-point a percentage point.
Also known as BPS or BIPS, basis points are important because they offer a high level of accuracy when keeping track of percentage changes for some financial values or rates.
The term “basis points” originated with interest rates as stock traders used to trade the “basis,” which meant the difference between two rates.
While this was often a very small percentage, traders have come up with other terms that are based off these points to represent bigger values, such as:
- GigaBips, or 1000 bps (10%)
- UltraBips, or 100 bps (1%)
- MegaBips, or 10 bps (0.1%)
Why basis points are used instead of percentages
Why do basis points get so much attention?
One of the main benefits of using basis points instead of percentages is the fact that it is a distinct value that stays constant as compared to a ratio.
If someone tells you that the price of a car has gone up by 30%, that will not tell you everything you need to know. 30% relative to what? Is that $1,000 or $10,000?
Basis points provide a form of absolute. Regardless of the amount of money invested, you can say the yield or price has increased by 25 basis points and traders will understand what you mean.
Basis points can also add up to a lot of money for retail traders and institutional investors.
In the bond market, if the yield on a Treasury bond jump from 1% to 1.10%, it is said to have moved by ten basis points or ten bips.
The value of a single bond trade could be tens of millions of dollars. Therefore, tiny changes in the current interest rates can have a huge dollar impact.
For a $20 million bond, a move of one basis point can affect the price of a bond by hundreds of dollars, contingent on the time to maturity and current interest rates.
Market experts also mention basis points when talking about the cost of exchange-traded funds and mutual funds. Fund expenses are typically denoted as an annual percentage of assets. For instance, the Vanguard Total Stock Market ETF has an expense ratio of 14 basis points, or 0.14%.
When traders are comparing fund expenses, they normally analyze the difference in basis points.
For example, a fund with an expense ratio of 0.37% is considered to be seven basis points more expensive than a fund with a 0.30% ratio.
While the difference in expenses might appear small, on $50,000 invested over 10 years, it can ttranslate to hundreds of dollars saved, depending on returns.
A basis point is the smallest unit of measurement in the world of finance and investing. This tiny measurement often makes a huge impact in the financial world.
They are often used by market analysts, traders, bankers, accountants, and other financial professionals use to discuss amounts that are lower than a percent.
They are a way traders communicate about changes in some financial instruments. Traders like to use basis points since they offer a highly accurate way to point out small changes in value.
It is important to understand how they work because changes of a few basis points could mean thousands of dollars in lower or higher interest paid or in returns lost or gained.
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Original source: https://www.warriortrading.com/basis-points/