A basis point is a unit equal to one hundredth of a percentage point.
A Basis Point (BPS) is simply, in financial terms, a unit that is used to measure a percentage change in the rate or value of a certain financial component. Hundred basis points combine to make a 1% change in value; this means that one basis point is equivalent to the hundredth of a percentage change in the any financial instrument e.g. bonds yields and interest rates.
Basis points serve as a convenient unit if measurement in cases where even the minutest of percentage changes matter. Other units are not able to calculate a very slight change in value; for changes that are very small, like changes in the interest rate, basis points can easily be used to measure a small increase or decrease in the value.
This term can be better understood with the use of an example. Assume that the Federal Reserve Board decides to change the interest rates by 25 basis points, which means the rates have increased by 0.25%. Similarly, a bond whose yield has increased from 5% to 5.5% has actually risen by 50 basis points. Basis points are very commonly used as a unit of measurement in the bond market. The basis point serves as a reference to the yield that a bond entails.
Most financial institutes frequently use basis points when they want to denote a small change in the value of a financial instrument. This is very common in the case of taxes, fixed income securities and interest rates.
Understanding the application and purpose of basis points, and successfully being able to calculate the impact these points have on bonds, interest and credit cards is vital for securing financial stability of individuals as well as large financial organizations, such as banks.
Some bonds and loans may often be quoted in relation to a certain underlying security or index. In these cases their value will be spread over, or sometimes, under, the index. This is so because the term 'basis point' has been derived from ‘basis’ something that is spread between two things i.e. interest rates, in this case.
Financial education is so important, but barely taught at all in our schools. Having resources online is great, but not if they are inaccessible to so many. Thanks 508!