Basis Point (BPS)

Published Aug 16, 2023

Definition of Basis Point (BPS)

A basis point (BPS) is a unit of measure used in finance to describe the percentage change in the value of a financial instrument. It is equal to 0.01%, or one hundredth of a percent. That means a change of one basis point is equivalent to 0.0001 in decimal form.

Example

To understand the concept of basis points, consider two scenarios involving interest rates and investment expenses. First, let’s examine interest rates in the context of a loan. Assume you’re dealing with a loan that carries an interest rate of 5%. This means the borrower is required to pay 5% of the loan amount as interest. Now, envision a situation where the interest rate climbs by 10 basis points. The new interest rate would be 5.1%. This indicates that the borrower now needs to allocate 5.1% of the loan amount towards interest payments. The change of just 10 basis points has led to a small yet measurable increase in the cost of borrowing.

Now, shifting our focus to investments, envision participating in a mutual fund that boasts an expense ratio of 1.25%. This ratio accounts for the portion of your investment allocated to covering the fund’s operational expenses. If the fund company makes a decision to reduce the expense ratio by 20 basis points, the revised expense ratio becomes 1.05%. Consequently, a smaller fraction of your investment—specifically 1.05%—will be directed towards the fund’s operational costs. This adjustment could potentially result in slightly enhanced returns on your investment. These examples emphasize how basis points serve as a crucial measure for expressing changes in percentages, be it in the realm of financial liabilities or investment costs.

Why Basis Points Matter

Basis points are an important tool for financial professionals because they allow them to measure small changes in the value of a financial instrument. That means they can use basis points to measure the impact of a change in interest rates, exchange rates, or other financial variables. In addition, basis points are also used to measure the performance of investments because they allow investors to compare the returns of different investments on a common scale.