Of basis points, beeps and bips: the atoms of interest rates

Wednesday, November 10, 2004 at 10am
By John Friedman

Today I have something short and purely educational for you.

Interest rates are in the news today. Greenspan et al. are meeting, and there is unanimous agreement among the punditocracy that he will raise short term interest rates (the only interest rates over which he has much power) by 0.25%.

Now you might hear people call that last figure 25 basis points. That’’s because, in the world of interest rates, a change in an interest rate of 0.01% can be quite noticeable, and therefore worthy of not being decimalized.

And that’s what a basis point is: it’s 0.01%.

And that means that 0.25%, being twenty-five times that slightest of percentage slivers, is 25 basis points.

You can think of a basis point as the atom of percentages, while 1.0% is the molecule.

This linguistic framework saves a lot of tongue-wagging, doesn’’t it? After all, would you rather say twenty-five basis points or would you rather say twenty-five hundredths of a percent?

Pity those who are sibilance stressed, as even the best of British actor enunciators must have to work hard and concentrate fully when uttering the word hundredths.

You’’ll often hear people say that a basis point is one one-hundredth of a percentage point. It’’s fine to think of it that way. Doing so is, after all, accurate. But most people find it easier to think of a basis point as the smallest slice of an interest rate that is noticeable, and to keep it in mind that there are 100 of those smallest slices in each percentage point.

And some people like to think of basis points as a second iteration, in that percentages are all about hundredths, and basis points are all about hundredths of hundredths.

With time, all of this becomes second nature..

The common abbreviation for basis points is bps, as in 25 bps. If you’re talking about one basis point, I suppose you might see it shown as 1 bp., but I cannot recall ever seeing that.

The bps abbreviation has given rise to some interest rate jargoning, so that, interest rate jargoneers everywhere refer to a basis point as a beep, or as a bip, as in, Greenspan is raising interest rates 25 beeps today.

Now you, too, can sound like an interest rate punditor.

* * *

Quick question: many people know the rule that “when interest rates go up bond prices go down and vice versa, but do you know why that is?

If you do not know The Vice Versa Rule, as I call it, and if you want to be smart about interest rates and bonds and such, you owe it to yourself to understand why it is so. Knowing that up/down rule is a start, but it is only that. To be smart in this arena you need to know the conceptual underpinnings of that rule.

But that is a topic for another day.

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