Basis Points | Definition, How It Works, & Percentage Conversion (2024)

What Are Basis Points?

Basis points (BPS) are a unit of measurement used in finance to describe changes in percentage values, such as interest rates or the yield of an investment. One basis point equals 0.01% or 0.0001 in decimal form.

BPS is especially important in reflecting changes that are less than 1%. It helps avoid confusion when dealing with small numbers, such as when calculating percentage changes in yields, spreads, or interest rates.

Basis points are commonly used in measuring interest rate hikes or cuts, changes in bond yields, or margin levels. For example, a 0.25% interest rate rise could be described as a 25 BPS increase.

Such minute changes can mean significant differences in the returns of an investment.

How Basis Points Work

Basis points are convenient for indicating rate changes without using cumbersome decimals. Moreover, since BPS uses whole numbers, they can express relative differences between rates in a less ambiguous way.

For instance, a 10% increase on a 10% interest rate might be understood as either 20% or 11%.

This is because you can compute the increase in two ways, either “10% + 10% = 20%” or “(0.10 x (1 + 0.10).”

To avoid this confusion, you can say that the interest rate increased by 100 basis points if you meant it rose to 11%. Conversely, if you meant 20%, you say the interest rate grew by 1,000 BPS.

Basis points also help when discussing incremental changes in a yield, such as a bond interest rate. Suppose you invested $1,000,000 in a government bond with 2.5% interest. After a year, the interest rate was lowered by 60 BPS, so newly issued bonds only pay 1.9%.

If you decide to resell it before its maturity date, your previously issued bond will be more attractive to investors since it pays $25,000 annually compared to new bonds, which may have the same face value but which pay $19,000.

Price Value of a Basis Point (PVBP)

The Price Value of a Basis Point (PVBP) indicates how much money is gained or lost due to a one basis point change in yield. It can be used to determine a single bond's price volatility or the relative yield difference between two similar bonds

For instance, let us say you invested $20,000 in a bond with a PVBP of $15.50, and there has been a 125 BPS change in your yield. Thus, your earnings grew by 1,937.50 ($15.50 x 125 BPS), and your investment is now worth 21,937.50 ($20,000+ $1,937.50).

Alternatively, when choosing between a bond with a PVBP of $15.50 or one with a PVBP of $20.50, remember that a higher PVBP means higher price volatility. Thus, if you choose the one with a higher PVBP, you can potentially earn more but also lose more.

The PVBP is crucial because it can help individuals assess potential risks, anticipate potential rewards, and make informed decisions about their investments.

Basis Points to Percentage Conversion

As we can see from the formula below, the conversion of basis points to percentages is easily accomplished by dividing the number of basis points by 100:

Percentage (%) = BPS ÷ 100

How Do Investors Use Basis Points?

Investors can use basis points to evaluate fees associated with two similar investments. For example, a mutual fund with an annual expense ratio (ER) of 0.50% and one with an annual ER of 0.45% has a difference of 50 BPS between them.

Although the numbers seem minute when stated in their percentage form, once converted to BPS, investors will have a clearer idea of the difference between these two and, thus, can choose the most appropriate one for them.

Basis points can also be used to measure the performance of an investment relative to a benchmark. For instance, if a fund manager outperforms a benchmark by 30 basis points in one quarter, it means that their return was 0.30% higher than the benchmark over that period.

Final Thoughts

Basis points are the smallest incremental measure used in finance. A single basis point equals 0.01% or 0.0001 in decimal form. BPs are commonly used when referring to changes in percentage values, such as interest rates or the yields of different bonds.

The PVBP is another term used when discussing basis points. It refers to the cost or benefit associated with a change in interest rate by one basis point. It can be used to determine a single bond's price volatility or the relative yield difference between two similar bonds.

The BPS and the PVBP give investors a more accurate idea of how much an asset has changed rather than relying solely on estimated percentages. By understanding both figures, investors can better assess the potential risks of investing in different financial products.

BPS and PVBP are just two of the ways in which you can evaluate different investment options. You may consult a qualified financial advisor to guide you in making more informed investment decisions.