A basis point value is a measurement of the effects of changes in yields on the value of financial instruments. It is used in the bond market to calculate the effect that a small change in interest rates would have on the value of a particular bond. The basis point value of bonds is important because it allows investors to measure the interest rate risk to which they are exposed by the purchase of a particular bond.
Basis points are units of measure used to describe changes in financial measurements. They are used in discussions of percentages, and 1 basis point is 1/100 of a percentage point. Investors use basis points instead of percentages because percentages can be misleading. For example, a 1 percent increase in the interest rate might mean that the interest rate increased from 2 to 3 percent, or it might mean that the rate itself increased 1 percent from 2 percent to 2.02 percent.
The term "basis point" is commonly used in connection with the activities of the Federal Reserve. For example, if the Fed decides to raise the interest rate from 2.00 percent to 2.25 percent, the financial news will report that the Fed raised interest rates by 25 basis points. Basis points also describe the relationship between a rate and its benchmark; a rate, for example, could be set at a certain number of basis points above a benchmark so that it moves with its underlying rate but maintains the same distance from it. The term is also used to discuss changes in percentages in other financial markets, like the changes in the yield on bonds.
The yield of a bond is the implied discount rate revealed by the market price of a bond and its payment stream. The payment stream of a bond is outlined in the bond contract, so it does not change due to market conditions. The yield, however, can change as a result of changes in price. The yield is calculated using the price, and if the price of a bond rises, then its yield is lower than it was before the price change.
The inverse relationship between the bond price and the yield means that an increase in the yield decreases the value of the bond; the basis point value tells investors the magnitude of that effect. The basis point value is found by calculating the yield of a bond, adding 1 basis point, and plugging that number back into the same formula to obtain the price the bond would have if the yield were 1 basis point higher. The difference between that price and the market price of the bond is the basis point value of the bond. This figure is easy to calculate, but it is also easy to make mistakes when doing the calculations frequently with complicated bond structures. This is why financial institutions continuously calculate basis point values using financial software on computers.