what is Basis Point

Basis points (BPS) are a fundamental unit of measure in finance, used to express small percentage changes in financial instruments such as interest rates, equity indices, and the yield of fixed-income securities. Here's a detailed understanding of BPS:

1. **Definition and Value**: A basis point is defined as 1/100th of 1%, or 0.01%. It is numerically equivalent to 1/10000 or 0.0001 in decimal form.
2. **Usage in Finance**:
- Basis points are crucial for clarity when discussing changes in interest rates or other financial variables. For instance, an interest rate increase from 10% to 10.01% is a 100 basis point rise.
- They are widely used in bond markets and lending rates, where small changes can have significant implications for investors and borrowers.
- In derivatives markets, such as SOFR futures, basis points are used to calculate the dollar value of changes in interest rates, which can affect the contract's value.
3. **Impact on Finances**: Basis point changes in interest rates directly affect the cost of borrowing and the returns on savings accounts. A change of 100 basis points can alter the rate of a loan or a bond by 1%, which is a substantial change in the financial domain.
4. **Calculations and Examples**: To convert between basis points and percentage points, you multiply or divide by 100. For example, 50 basis points is equivalent to 0.5%. If the value of a SOFR futures contract changes by 1 basis point, it moves by $25, highlighting the dollar value of even small percentage changes.
5. **Importance in Financial Decision Making**: Investors and analysts use basis points to assess the potential impact of interest rate changes on the value of assets. This is particularly important in fixed income securities and loans, where small changes in interest rates can lead to significant changes in the present value of cash flows.

In conclusion, basis points are a critical tool in the finance industry, facilitating precise communication about small percentage changes and their potential financial impacts.