A basis point is a frequently used unit of measurement that indicates fluctuations in interest rates and percentages.
What Are Basis Points?
Basis points, abbreviated (bps), are a simplified version of an interest rate. For example, they are 1/100th of 1%, or one might say that 1 Basis Point equals 0.01%.
Bps are the smallest units used in finance and have a variety of applications in places where minute percentages are being calculated. For example, financial technicians, analysts and accountants use bps regularly.
Investors adopt the concept of a basis point to convey the costs of exchange and mutual funds. The basis point greatly impacts most financial instruments, such as bonds, common stocks and mortgage loans. Investors incur expenses and certain funds fees when they apply basis points. It is also used to express the change in the value of mutual commodities.
How to Calculate Basis Point?
Basis points are easily converted from percentages by just multiplying by 100. However, the alternative calculation proves just as useful when the convergence from percentage to basis point occurs.
For example, if 0.5% is equivalent to 50 BPS, 1000 BPS will equal 10%. How to convert the basis point to a percentage and vice versa is shown below.
Basis Point = Percentage * 100
Percentage = Basis Point / 100
Example of Basis Point
Consider the following scenarios. The ABC contract has a worth of 1,000,000. In order to track the three-month rate for the contract with the rate increasing from 1% to 0.95%, we plug the values into the formula as follows:
Basis Point = 1,000,000 * (90/360) * 0.005
Basis Point = 1250-unit cost
In the case of bonds, it is stated that a 10 BPS has increased the bond yield by five years. The percentage equivalent of 10 BPS would be 0.1%. Given that the yield on the bond of the past five years was 5.60%, what would be the current percentage yield?
The current percentage yield is the sum of the previous yield added to the BPS. 5.6 + 0.1 = 5.7%
Consider two bond contracts, A and B. The interest rate of A is said to be 11.2%, while the interest rate of B is 12. % The difference between A and B is calculated to be 0.8% which is also equal to 80 Basis Points. Company X experiences a gain in profit when the interest rate rises from 0.985 to 0.935 again or increases by the value of 50 BPS.
What Is the Usage of Basis Point?
Basis points have the most applications in the calculations of equity, loan and bond payments. Also, basis points make it easier to handle small percentages. These percentages are usually minimal but majorly impact the economy.
BPS mainly occurs in the calculations of yield spreads or interest rates. The difference between interest rates is known as yield spreads. Yield spreads are used in savings and mortgage account calculations. For example, if there is a savings account with an interest rate of 5% and a loan account with 3%, then the yield spread rate is 2%. The basis point value associated with 2% is 200 bps.
Also, BPS is observed during the risk assessment procedure. Besides, this value simplifies the effect different interest rates might apply on the monetary value. For example, an increase of 1% would add 100 basis points to the principal.
BPS’s use is not limited to the fields mentioned above. It is also used in the loan or bond investment side. Equity and debt security mechanisms also use it to simplify and clarify their solutions. Finally, call derivatives also use BPS directly.
Basis Points vs Percentages
Basis points and percentages might look very similar. Still, they have distinct features. Percentages are dependent on multiple values; hence when there is an increase in the percentage by 1%, it has a different effect based on the relative and absolute values. For example, the rate might be 1% according to the absolute method and 9.09% using the comparative method.
Basis Points eradicate this confusion by declaring 1% equivalent to 100 BPS.