Basis Points Essay ⋆ Business Essay Examples ⋆ EssayEmpire

A basis point is a unit of measurement in the market for loan finance used by the market participants in relation to interest rates and bond yields. One basis point is one percent of one percent. The system of basis points is, therefore, grounded in the decimal system (Base 10). Interest rates are frequently quoted to three or four decimal points. One basis point equals 0.01 percent, 100 basis points equal 1.0 percent. For instance, if an interest rate changes from 4.65 percent to 4.67 percent it has changed by 2 basis points. A change from 4.6525 percent to 4.6757 percent would represent 2.32 basis points.

In relation to large principal sums, the money value of a basis point can be significant. For some transactions involving very large sums and very fine rates, even a basis point may be too large for practical purposes. In some instances hundredths or, even thousandths, of a basis point may be appropriate. For example, in a debt issue of $5 billion a hundredth of a basis point would be worth half a million dollars.

Basis points have become established as a common terminology that is useful for expressing small differences in interest rates, and they indicate the low order of magnitude at which the financial markets work. The term is usually abbreviated in use to BP, bp, or bip. It is more convenient, for example, to talk of 25 basis points rather than 0.25 percent, which offers potential for ambiguity and confusion. Given the small changes in interest rates with which the financial markets deal, it is appropriate to have a suitably calibrated measurement. The change in money value of a bond price in relation to a one basis point change in its yield is referred to as the basis point value. The term basis point should not be confused with basis, which is the term used to describe the difference between a futures contract price and a spot price.

Basis points are used to express a spread over a benchmark interest rate for a particular borrower. For fixed interest rates the benchmark will usually be a government bond rate and for floating (variable) interest rates a benchmark such as LIBOR (London Interbank Offered Rate) will be used. A company might, for example, arrange a 10-year floating-rate loan at LIBOR+ 75 basis points. If LIBOR were 4.375 percent, this would represent a rate of 5.125 percent. The spread in basis points will remain constant but the variability of the rate will be derived from the movement of the benchmark rate, which will change. The floating rate the company pays would vary with movements in LIBOR and the rate would be changed at agreed intervals, perhaps every six months.

Basis points are also used in pricing certain derivative instruments. For example, the premium for a credit default swap (CDS) will be expressed in basis points, representing the annual payment the bondholder will make to the seller of the swap, who assumes in return the default risk on the bond. The premium will be calculated as basis points of the face value of the bond. In the market for exchange-traded interest rate futures contracts, the minimum interest rate movement allowable is expressed in a unit known as a “tick,” which is denominated in terms of basis points of interest. The tick size will vary from contract to contract. For example, the tick size for a three-month eurodollar interest rate futures contract traded in Chicago will be one basis point, whereas for a three-month euro LIBOR futures contract traded in London the tick size will be half a basis point.

Bibliography:

Blake, Financial Market Analysis (John Wiley, 2001);
Durbin, All About Derivatives (McGrawHill, 2006);
Valdez, An Introduction to Global Financial Markets (Palgrave Macmillan, 2007).

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