What is Basis Point and Why is It Important for Investors?
A basis point is a standard metric to measure changes in interest rates, yields from financial securities or any other debt instruments. One bp or basis point is equivalent to 1/100th of one percent. 1 Bp means 0.01% change, 100 Bp means 1% change, and 10000 Bps is equivalent to 100% change. Therefore, if the interest rate changes from 10% to 10.01%, it means that there has been a one basis point increase in interest rates.
Read on to understand the importance of basis points, formula, calculation, examples, benefits and more.
Why are Basis Points Important?
Although they are small, their impact on the overall financial industry is huge. Basis points in finance are a critical component for the efficient functioning of the overall economy. Even a small change in bps indicates a shift of billions or millions of dollars in an economy.
The credit card industry, mortgage sector and other debt instruments are greatly influenced by basis points. Another reason why they are important is that they remove any confusion when one is analysing changes occurring in interest rates.
For example, let’s say that the repo rate, or the interest rate on loans offered to banks by the Reserve Bank of India, is set at 6% at the start of FY 2022. However, due to inflationary pressures, there has been an increase in the repo rate by 1%. There might be some confusion as a one percent increase in relative terms would mean the new repo rate is 7%.
On the other hand, in absolute terms, it would mean that the new repo rate translates to 6.10%. However, if we consider basis points and tell that the Reserve Bank of India has increased basis points by 100, it would mean that the new repo rate stands at 7%.
What is the Formula to Calculate Basis Point?
Here is the formula associated with this:
BP or basis point = 1/ (interest rate) * 100;
It means that in order to calculate basis points, we must divide 1 by the prevailing interest rate and then multiply the result by 100.
How are Basis Points Calculated?
One crucial point to remember is that one basis point is equal to 0.01% or 0.0001. If you want to calculate the percentage into basis points, you can divide the basis point by 100.
Let’s convert 3% into bps. For this, you need to divide 3% or 0.03 by 100, and you will get the result of 0.03. In the next step, divide 0.03 by 0.0001, and you will get the result as 300 Bps.
Example of Basis Points
Let’s understand this concept more clearly and lucidly with the help of an example. Suppose Mr. Singh wants to invest in a government bond that offers an interest rate of 12.50%. After some months, interest or coupon rates of the same fell to 12.15%. Therefore, you can measure a change in interest rate with the help of basis points.
As per the formula mentioned above, the change in interest rates in this scenario is equal to 35 basis points. We can safely conclude that the interest rate has fallen by 35 basis points for the said bond.
How to Convert Basis Points in Percentage?
If you wish to convert basis points into percentages, you must multiply by 100.
Let’s say there are 300 basis points, and you wish to convert the same into a percentage. In this scenario, you should first multiply 300 by 0.0001 to get = 0.03. Remember, as discussed before, one basis point is equal to 0.01% or 0.0001.
In the next step, you multiply the result by 100, which is equal to 3%. Therefore, 300 basis points mean a 3% percentage.
Basis Points Are Applied to Which Instruments?
Here are some instruments in which you can use basis points:
1. Corporate Bonds
It is a debt instrument that corporate houses issue in order to raise funds for financing their needs. Any change in interest or coupon rate can be measured by basis points.
2. Treasury Bonds
These are funding instruments issued by federal or state governments. Again, basis points can be helpful if we wish to analyse changes occurring in interest rates. It will simplify our understanding of returns from treasury bonds.
3. Interest Rates
Changes occurring in interest rates determined by Central banks or commercial banks will be visible from basis points.
4. Credit Card Instruments
Again, changes occur in the interest rates of credit cards. You can analyse the same using Bps or basis points.
5. Equity Instruments
All minute changes below one percentage occurring in equity instruments can be assessed by calculating the basis points.
6. Futures and Options
One can also use bps calculation to assess the changes occurring in the return rate of stock market derivatives like futures and options.
What Are the Benefits of Basis Points?
Here are some benefits of using the basis point metric:
- It helps in avoiding confusion when dealing with small changes in percentage points. You can use them to get an accurate estimate of changes in the percentage of various instruments.
- This tool also helps in clearly differentiating or demarcating between absolute and relative changes occurring in interest rates. There is no ambiguity when we use it.
- Basis points will allow individuals or investors to track changes occurring in stock indices.
- It is easy to understand and communicate any changes occurring in the value of an asset using the points-oriented Bps system rather than percentages. Clear communication in the financial world is paramount for the effective functioning of the fundamentals.
Why Do Investors Use Basis Points?
Investors and analysts use basis points to analyse changes occurring in interest rates of various instruments like bonds, credit cards, etc. Another reason why they use basis points is to clear ambiguity regarding absolute and relative changes occurring in various rates.
Suppose the repo rate has gone up from 5% to 6%. Some may consider this as an absolute change of one percent. On the other hand, many would argue that it is a relative change of 5.01%. This will lead to a lot of confusion; hence, investors use basis points and say there is a rise of 100 Bps, which leads to effective communication.
Final Word
The basis point is an efficient financial metric that measures changes occurring in interest rates for loans and other debt instruments. It clears all ambiguities associated with the rate change. Investors and market analysts tend to use this calculation system instead of using percentages to convey the change in values effectively.
FAQs
Ans: Using measurement values of 1 Bps equal to 0.01%, 75 basis points would be equivalent to 0.75% in percentage terms and 0.0075 in decimal.
Ans: Depending on the kind of mortgage that you are opting for and prevailing interest rates, basis points will affect your equated monthly payments or EMI and the total interest component of your loan amount.
Ans: Yes, they can be negative in regular parlance. However, positive or negative basis points will depend on the directional change in interest rates. A negative basis point may imply a fall or reduction in interest rates.
Ans:. In the financial sector, most individuals prefer using basis points over percentages as they are convenient. They are less ambiguous than percentages as they represent a set figure instead of a ratio.
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Disclaimer: This article has been prepared on the basis of internal data, publicly available information and other sources believed to be reliable. The information contained in this article is for general purposes only and not a complete disclosure of every material fact. It should not be construed as investment advice to any party. The article does not warrant the completeness or accuracy of the information, and disclaims all liabilities, losses and damages arising out of the use of this information. Readers shall be fully liable/responsible for any decision taken on the basis of this article.
