Definition:
A basis point, often abbreviated as “bps” (pronounced “bips”), is a unit of measure equal to one-hundredth of a percentage point (0.01%). Basis points are commonly used in finance to quantify small changes in interest rates, bond yields, or financial percentages.
Understanding basis points in context
- Interest rates: Basis points help describe rate changes with precision. For instance, if the Bank of Canada raises its key interest rate from 4.00% to 4.25%, this is an increase of 25 basis points.
- Spreads and margins: In lending or trading, the difference between the interest rate charged and the cost of funds might be expressed in basis points. This is often the case for mortgage rates, bond spreads, or profit margins.
Why use basis points?
Basis points eliminate ambiguity in percentage changes. Describing changes in percentages can lead to confusion (e.g., a 1% increase could mean an absolute increase of 1% or a relative increase of 1%). Basis points provide a clearer, standardized way to express these changes.
Examples of basis points in use
- Central bank policies: A central bank might cut rates by 50 basis points to stimulate economic activity.
- Investment yields: A bond yield increasing by 30 basis points represents a 0.30% increase.
- Loan pricing: In mortgage terms, lenders may adjust rates up or down by a few basis points based on the market or risk factors.
Conversion of basis points to percentage
To convert basis points to a percentage, divide the basis points by 100. For example:
- 25 basis points = 0.25%
- 100 basis points = 1%
Basis points and financial markets
Basis points are essential in financial markets, as they enable precise and standardized communication of rate changes, helping investors, analysts, and policymakers make informed decisions.
Last modified: November 5, 2024
