Basis Point (BPS)
A basis point equals one-hundredth of a percentage point (that is, 1 BPS = 0.01 percentage point). A BPS is typically referred to as ‱. It is the smallest unit of measure for changes in interest rates on financial instruments.
What Is a Basis Point (BPS)?
It is a unit that equals 1/100 of 1%, which is used to indicate changes in the price of a financial instrument. A BPS is used to calculate changes in interest rates, stock indexes, and returns on fixed income securities.
The ratio between percentage changes and basis points can be expressed as follows: 1% change = 100 BPS, and 0.01% = 1 BPS.
A bond the yield of which increases from 7% to 7.5%, increases the yield by 50 BPS.
Interest rates, which rose by 2%, are said to have risen by 200 BPS.
Converting Basis Points to Percentage
The easiest way to convert BPS to percentage is to simply take the number of base points and multiply it by 0.0001, which will give us the percentage in decimal form.
Therefore, if you need to convert 255 BPS to percentages, just multiply 255 by 0.0001. This will give you 0.0255 or 2.55% (0.0255 x 100).
You can also do it in the reverse order by dividing the percentage (in decimal form) by 0.0001.
For example, if the bond rate increased by 3.67%, just take 0.0367 (3.67% / 100), divide by 0.0001, and you will get 367 BPS.
Where to Use a Basis Point
The primary purpose of a BPS is to eliminate confusion that occurs due to constant changes in interest rates. Examples:
It was previously noted that the rate, which was 5 percent, increased by 2 percentage points, then this situation could be interpreted in two ways, depending on how you calculated: either literally, i.e. 5 + 2 = 7%, or by assuming that 2 percent is taken into account from the previous value, so 5 + (5/100) * 2 = 5.1 percent.
The rate was 10% and is announced to have been increased by 1 percentage point. It means that the new value will be 10% + 1% = 11%. But it can be understood that the increase occurred at 1% of the previous value: 10 x (100 + 1) / 100 = 10.1%. Therefore, changes in interest rates are indicated in basis points. Announcement of a rate increase of 20 BPS for this example would mean 10% + 0.01% * 20 = 10.20%.
These examples demonstrate that with different interpretations you can get completely different interest rate indicators. BPS was introduced to avoid such double values. Other uses of a basis point are as follows.
Mortgage Rates Prediction
To quickly calculate long term fixed mortgage rates, investors routinely add 170 basis points to the 10-year treasury note interest rate. The 170 BPS rule of thumb is not precise, but it is a convenient way to determine the direction of mortgage rates. If you had a choice between owning a $100,000 mortgage-backed security and a $100,000 10-year treasury note, you would earn about $1,700 more a year on the mortgage-backed security to compensate for the risk — $170 per $10,000 multiplied by 10.
Credit Card Processing Fees
Fees that are charged for credit card transactions can significantly reduce the budget of small business owners. BPS can help cut down those expenses a little. The fees consist of two parts: interchange fees and the processor's markup. The interchange fee is non-negotiable and goes directly to the sender's bank. Processor markups are expressed in BPS and vary by the processing company. So, when comparing the competitiveness of proposals from processing companies, pay extra attention to their basis point markups. For example, if you are averaging $10,000 a month in credit card transactions, the difference between a 500 and a 300 BPS markup is $200 a month — $500 minus $300.
Price Value of a Basis Point (PVBP)
The PVBP is an absolute sensitivity measure for interest rate instruments (or their existing portfolios), which is used to understand the interest-induced price risk. For example, fixed income securities indicate to the PVBP how much the dirty price of security changes when the return is one basis point, i.e. 0.01%. The calculation is made according to this formula:
PVBP = (Modified Duration x Dirty Price) / 10,000,
where the modified duration is the average cash-weighted term to maturity of a bond and the dirty price is the cost of a bond that includes accrued interest.
The Bottom Line
A basis point is the smallest unit of measure used to calculate fluctuations in interest rates for financial instruments, typically government bonds, treasury notes, and mortgage-backed securities. The primary purpose of a BPS is to eliminate the ambiguity that occurs because of ongoing changes in interest rates. It can also be used to predict the mortgage rates and help small business owners to save on credit card processing fees.