Definition: Basis points (BPS) are the smallest measurement of fixed income securities and interest rate quotes and are used to measure changes and differentials in interest rates and margins.
What Does Basis Points Mean?
What is the definition of basis points? Financial analysts and investors use bps when they want to express minor percentage changes. For instance, a difference of 0.05% in the performance of two stocks in a portfolio can be expressed as a difference of 5 bps, instead of “zero point zero five percent.” Or, when people read in the newspaper that “the Fed cuts the interest rates by 35 bps,” it means that the Fed cuts the interest rates by 0.35%. Therefore, 1 bps is equal to 0.01%.
Let’s look at an example.
Example
Alex is a retail investor who follows the stock market and likes to be informed about the macroeconomic environment. He reads the newspaper daily, and he is mostly interested in the Fed news and the moves of the Federal Reserve with respect to the interest rates.
Alex reads in the newspaper that the Fed is inclined to cut the interest rates by 25bps. As he is not sure of what “25 bps” exactly means, he makes a phone call to his best friend, Jerry, who perhaps knows what “bps” means.
Jerry explains to Alex that 25bps are equal to 0.25% since 1 bps is equal to 0.01%. He also offers an example with the interest rate on his mortgage. The mortgage has a floating interest rate of LIBOR +75bps. This means that the floating rate is 4.00% because the LIBOR is 3.25%. Therefore, 3.25% + 0.75% = 4.00%.
Basis points are widely used by financial analysts because they provide an accurate indication of the difference between two percentages even if this difference is minor. For instance, analysts that follow the 20-year U.S. T-Bills daily can accurately calculate the small changes in the index movement, which, however, may have a major impact on the economy.
Summary Definition
Define Basis Points: A Basis point means a fractional measurement for financial investing returns and interest percentages.
