Last Updated on May 24, 2022 by Anjali Chourasiya
We have often come across the term ‘bps’ in the newspapers, especially when the RBI announces changes in the policy rate. Bps stands for ‘basis points’, a standard unit of measure in finance for interest rates and other percentages. The term basis point is derived from Latin, meaning ‘support’ or ‘foundation.’
Bps or basis points are also expressed as bp or bips. But what does bps mean to investment instruments? How is bps employed in daily life?
Let us find out!
Table of Contents
What is bps?
The bps is a unit to measure the percentage change in the value of various financial instruments. It is used to calculate changes in interest rates, equity indices, and fixed-income security yields, among others.
The ‘basis’ in basis point refers to the base move between two percentages or the spread between interest rates. Usually, the recorded changes are narrow, and since the minor changes have outsized outcomes, the basis is a fraction of the percent. Traders often refer to bps while comparing changes amongst two instruments.
Basis points are also commonly used to compare management expense ratios (MERs) of investment products.
Interpreting bps
One bps equals 1/100th of 1%, or 0.01%, or 0.0001. This is the percentage change in the value of a financial instrument. The formula for determining the link between percentage changes and basis points is:
1% change = 100 basis points; and 0.01% = 1 bps
Furthermore, bonds and loans are commonly quoted in basis point terms. For instance, it is quite common to say that the interest rate offered by ABC Bank is 50 basis points higher than XYZ’s.
Usually, it is said that a bond whose yield increases from 5% to 5.5% increases by 50 basis points, or interest rates that have risen 1% are said to have increased by 100 basis points.
For instance, if the RBI increases the target interest rate by 25 bps, it means that the rates have increased by 0.25% percentage points. If the rates were at 2.50%, and the RBI raised them by 25 basis points, the new interest rate would be 2.75%. If the RBI has reduced the repo rate by 25 bps and the initial repo rate was 4.50%, then the new rate will be 4.25%.
The same applies to bonds. If the bond yields of 10 yrs GOI bonds increase by 20 bps in the last month, it means that the yield on bonds has risen by 0.20%. Suppose the yield on 10 yrs GOI bonds was 7.90% a month ago, the current yield on bonds will be 8.10%.
Price value of a basis point
The price value of a basis point, commonly known as the PVBP, measures the absolute value of the change in the bond’s price for one basis point change in yield. PVBP is another way to measure interest-rate risk. Similar to duration, it measures the percent change in a bond price given a 1% change in rates.
Instead of using a 100 basis point change, the PVBP only uses a 1 basis point change. An increase or decrease in rates is not taken into account as a small move in rates is usually the same in either direction.
Bps and investments
Basis points are also used in the context of mutual funds and exchange-traded funds (ETFs). For instance, a mutual fund with an annual management expense ratio (MER) of 0.15% is quoted to have an expense ratio of 15 bps.
Bps offers clarity on the difference between the cost of investment in various funds. For example, an analyst may say that a fund with 0.35% in expenses is 10 bps lower than another with an annual expense of 0.45%.
Basis points vs percentages
Traders mainly use BPS over percentage mainly for convenience and to avoid ambiguity that may arise while talking about percentage moves. It also helps to expedite communications and avoid trading mistakes.
The values of most financial instruments are highly sensitive to even small changes in underlying interest rates; therefore, having clarity is crucial for traders. Let’s understand this better with an example.
Assume a financial instrument is priced at a 10% interest rate, and there is a 10% increase. Now, this could either mean that it is now 0.10 x (1 + 0.10) = 11%, or it could also mean 10% + 10% = 20%.
In the end, the intention is unclear. In such cases, the use of basis points makes the meaning obvious. If the instrument is priced at a 10% interest rate and increases by 100 bp, it is now 11%. The 20% result would only occur if there were instead a move of 1,000 bps.
Conclusion
The RBI and various other financial institutions extensively use bps for communicating rate changes and others. Not fully understanding how a bps should be interpreted can land an investor in an unpleasant situation. It is, therefore, essential to understand the nuances of basis points as many financial instruments have their changes measured using this unit.
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