WHY ARE BPS USED IN FINANCE

The world of finance buzzes with terms and phrases that might leave the average person perplexed, and somewhere amid these perplexing notions lies the concept of basis points or bps. These little letter combinations hold significant weight in the financial realm, so let's demystify what bps are and why they matter to financiers.

Understanding Basis Points

Picture this: you're baking a cake, and the recipe calls for 200 grams of sugar. If you accidentally add an extra gram, you won't ruin the cake. It's a minuscule change, almost unnoticeable. In the world of finance, that extra gram would be referred to as 5 basis points.

To put it simply, basis points (bps) are a unit of measurement used to represent a percentage change, typically in interest rates, yields, or spreads. It's a convenient way to express minute variations in financial terms, much like how millimeters are used to measure tiny changes in distances.

Using Basis Points in Finance

Basis points find their applications in various financial contexts:

1. Interest Rate Changes:

When central banks adjust interest rates, they rarely make dramatic leaps—they usually tweak them in small increments. These tiny adjustments are expressed in basis points. For instance, if the Fed raises the benchmark interest rate by 0.25 percentage points, it's equivalent to a 25-basis point increase.

2. Bond Yields:

Bonds, essentially IOUs issued by governments and corporations, carry yields that represent the annualized interest payments they offer. When bond yields fluctuate, they do so in basis points, mirroring changes in the broader interest rate environment.

3. Credit Spreads:

Credit spreads measure the difference between the yields on corporate bonds and government bonds. Higher credit spreads indicate higher risk associated with the corporate bonds. Changes in credit spreads are also expressed in basis points.

Why Use Basis Points?

Finance professionals prefer using basis points for several reasons:

1. Precision:

Since basis points represent hundredths of a percentage point, they allow for precise measurements of financial changes. Percentages, on the other hand, can be more ambiguous, especially when dealing with small variations.

2. Universal Understanding:

Basis points are standardized across the financial industry, providing a common language for professionals globally. It eliminates confusion and enables easy comparison and understanding of financial data.

3. Convenience:

Expressing variations in basis points makes calculations simpler and more manageable. For instance, calculating the difference between a yield of 3.25% and 3.50% is less cumbersome when using basis points (25 bps) than percentages.

Conclusion

Basis points, though seemingly insignificant at first glance, play a crucial role in the world of finance. They provide a precise, universal, and convenient way to measure and communicate tiny changes in interest rates, bond yields, and credit spreads. As a result, bps have become an indispensable tool for financiers, enabling them to navigate the complexities of financial markets with greater accuracy and precision.

FAQs on Basis Points in Finance

1. How do basis points relate to percentages?

• Basis points are hundredths of a percentage point. So, 100 basis points equal 1 percentage point.

2. Why are basis points used in finance?

• Basis points provide a precise, universal, and convenient way to measure and communicate tiny changes in financial terms.

3. Where are basis points used in finance?

• Basis points are used to express changes in interest rates, bond yields, and credit spreads.

4. How can I calculate the difference between two yields using basis points?

• Subtract the lower yield from the higher yield. For example, if the higher yield is 3.75% and the lower yield is 3.50%, the difference is 25 basis points (0.25%).

5. What are some examples of basis point movements in the financial markets?

• If the central bank raises the benchmark interest rate by 0.25 percentage points, it's equivalent to a 25-basis point increase.
• If a bond's yield decreases from 4.25% to 4.00%, that represents a 25-basis point decline.
• If the credit spread between a corporate bond and a government bond widens from 100 basis points to 125 basis points, that's a 25-basis point increase in the spread.