Calculating basis points is a matter of performing a very basic arithmetical formula. Basis points are often abbreviated to bp or bps, and they are the equivalent of 1/100th of one percentage point, and thus it can be expressed as 0.01 percent or 0.0001.
When it comes to interest rate calculations, we can multiply the percentage rate by 100 for the purpose of finding the number of basis points, and so 0.25 percent multiplied by 100 equals 25 basis points. Conversely, basis points can be converted to percentages by means of division; for example, 125 bps divided by 100 equals 1.25 percent.
Basis points are widely used in the field of finance whenever very large quantities are alluded to; for example, when the Board of Governors of the Federal Reserve Bank of the United States convenes to set the prime rate, a small increase or decrease of just half a percent is pretty significant and will be felt across the financial spectrum. Once banks are aware of this shift in the prime rate, they will move to price their products in basis points. For example, if the Fed decides to set the prime rate at 1.5 percent, some banks may seek to add a couple of basis points to this rate and apply it to their money market accounts. A similar situation would apply to residential finance products, whereby a funding fee or a commission paid to a broker can be set in bps, which are called “bips” in the mortgage lending industry.
Individuals who work in the investment banking field use basis points extensively. Wall Street and the financial industry are ruled by percentages and basis points, which provide a much needed uniformity in communications across the global financial markets. A corporate bond trader in London can offer his or her counterparts in Dallas a new issue that pays 50 bps over the LIBOR; such an expression will help the traders in Dallas to quickly understand the price and how much this particular bond could pay.
Basis points have been adopted by the financial industry because they help to illustrate the base move that can be calculated when two percentages move against each other. When observing a significant financial benchmark such as the 10-Year U.S. Treasury Bill on a daily basis, even the most seemingly small changes can result in systemic changes, and thus it helps to evaluate them with a comfortable unit of measurement such as bps.
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Author: Jay White
I started Dumb Little Man so great authors, writers and bloggers could share their life "hacks" and tips for success with everyone. I hope you find something you like!