Concept of basis point
A basis point means a unit of measure. It is a percentage indicator and each base point corresponds to 0.01 percentage points, whereby a change of 1% is equivalent to a change of 100 basis points.
In finance, this unit of measure is very important since it is used to express variations of financial instruments. For example, central bank central bank interest rates are normally changed by multiples of 25 basis points.
Examples
The base point is commonly used to calculate changes in interest rates, stock indexes and the yield of a fixed income security. For example, you can say that the interest rate offered by your bank is 100 basis points above the Euribor. A link whose yield increases from 4% to 4.5% is said to increase by 50 basis points, or interest rates that rose 1% are said to have increased by 100 basis points. Or, if the European Central Bank (ECB) raises the basic interest rate by 50 basis points, this means that rates have risen by 0.50% percentage points. If rates were at 2.25%, and the ECB raised them by 0.50% or 50 basis points, the new interest rate would be 2.75%.
In another example, if the price of a fixed-income financial instrument is determined at a rate of 10% and that rate is increased by 10%, it means that the price of that financial instrument will be given by 10% x (1 + 0, 10) = 11%. However, to say that the increase was 10% can also mean 10% + 10% = 20%. Therefore, using base points, the meaning is clearer: if the instrument has the price equivalent to a rate of 10% and this rate increases by 100 basis points, as 100 basis points equal 1%, then the new price of that financial instrument shall be 11%.
It is also another way to measure interest rate risk, similar to duration.
