A basis point, often abbreviated as “bps,” is a fundamental unit of measurement in finance, particularly relevant when discussing interest rates, bond yields, and other percentage-based metrics. One basis point equals 0.01%, or one one-hundredth of a percent. This small unit helps traders, analysts, and investors express changes in rates or yields more precisely and avoid confusion.

To put it simply, if an interest rate rises from 2.00% to 2.25%, the increase is 25 basis points. This precision is important because financial markets frequently deal with very small changes in rates that can have significant impacts on investment returns or costs of borrowing.

Formula:
Change in basis points = (New Rate – Old Rate) × 10,000

For example, if a bond yield moves from 3.15% to 3.45%, the change in basis points is (3.45 – 3.15) × 10,000 = 30 basis points.

Why use basis points instead of percentages? Consider an interest rate change described as “0.25% increase.” While this sounds straightforward, in financial markets, saying “25 basis points” is more precise and reduces ambiguity. For instance, a 0.25% increase could be misinterpreted as either an additive 0.25 percentage points or a 0.25 percent relative increase. Using basis points clarifies that the increase is exactly 0.25 percentage points.

A practical trading example involves foreign exchange (FX) markets. Suppose the US Federal Reserve announces a rate hike of 50 basis points, increasing the federal funds rate from 1.75% to 2.25%. Traders in currency pairs like USD/EUR or USD/JPY react quickly to this news. Because interest rates influence currency strength—higher rates typically attract more foreign capital—the 50 basis point hike can lead to a stronger US dollar. CFD traders on indices like the S&P 500 may also see volatility as higher interest rates impact corporate earnings expectations.

One common misconception is confusing basis points with percentage points. A percentage point is a full 1% change. For example, moving from 2% to 3% is a 1 percentage point increase, or 100 basis points. Meanwhile, a 1% change relative to 2% (i.e., 2% increasing by 1% of itself) is only a 2.02% rate, which is 2 basis points, not 100. Remembering this distinction is critical to avoid miscommunication.

Another mistake traders sometimes make is forgetting to convert basis points into decimal form when calculating returns or costs. For instance, a 25 basis point fee should be input as 0.0025 (25 ÷ 10,000) in formulas, not 0.25 or 25.

Related queries people often search for include: “How many basis points in 1%?”, “What is the difference between basis points and percentage points?”, and “Why are basis points used in bond yields?” Understanding these questions helps clarify the importance of basis points in evaluating small yet impactful changes in financial metrics.

In summary, basis points are an essential tool in trading and finance for expressing very small changes in interest rates, yields, and other financial indicators. Using basis points improves clarity, reduces misinterpretation, and enables precise communication in markets where fractions of a percent can make a significant difference.