What's the deal with "basis points"? Like if the Fed lowers interest rates from 4.5% to 4.25% why is that called a cut of 25 "basis points" instead of percentage points?
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Important Monetary Policy Question
18 Mar 2008 09:03 am
Comments (45)
Probably at this point we should just call it what it is, namely "shitting our pants".
They are fractions of a percentage points. You can also call them bips (Bps)
It's more clear on first read. If you reduce a percentage by a percentage, are you performing subtraction or multiplication? It's not always obvious, but basis points provide an unambiguous remedy to that problem.
It's finance jargon used to avoid talking about decimal points when practically every number you use follows a decimal point. Kinda silly to use in journalism, IMO, but useful if you're, say, a bond trader.
Because single-digit units should be meaningful.
That's why instead of talking about how many tens of thousands of feet one city is from another, we talk about how many miles, and why instead of talking about how many billions of miles one star is from another, we talk about how many light years.
So: if you're trading in a market where moves of hundredths of a percentage point are routinely meaningful, and movements of a percentage point or more are extraordinary, you come up with a name for "hundredth of a percentage point" - a basis point.
Come on, Matt.
In fact, Matt, if talking about basis points is silly, why isn't talking about percentage points silly? Why don't people say the interest rate on your loan is 0.0625 per year instead of 6.25% per year?
What's the deal with inches? Why don't we just call them one-twelfth of a foot?
And what's the deal with airplane food?
Basis points are the unit of measure in the financial marketplace. It’s roughly equivalent to talking in cents rather than in fractions of a dollar, and thus facilitates rapid mental manipulation —in a trading situation, e.g. Since the yields on two different securities can differ by just a few basis points – and that differential can be very meaninful in the financial markets – it’s easier to describe that differential in basis points rather than fractions of a percent.
It also helps reduce confusion. if you say "point zero two five percent," you mean 0.025%, or .00025, but people can easily get confused and think you mean 0.025, or 2.5%.
also useful in "jargoning" your unsuspecting clients into submission. If a loss, it is a quarter of a percent; a gain, 25 bip gain -- booyah.
Okay, at the risk of inviting abuse for failing to find some snarky angle-or-other to answer this question, my sheer guess is that this is because, in almost any counting system, you tend to give a name to whatever the smallest unit of change is in your system.
For instance, we physics types tent to talk about the wavelength of light in nanometers. This is because it's easier to say that the wavelength of a HeNe laser is 632 nm, rather than saying that it's "oh point oh-oh-oh-oh-oh-oh-six-three-two meters."
On the other hand, surveyors measure things in meters or kilometers, because it would be ridiculous to describe the height of Mount Kilimanjaro as "four quadrillion, eight hundred ninety-five trillion nanometers."
Similarly, the smallest unit I see these interest rates set is in hundredths of a percent. Hence, that unit gets a name, 'basis points,' because it's easier to say "twenty-five basis points" than to say "oh point two-five percent."
I think the reason this is a natural tendency is not only laziness, but also that people deal better with comparing the size of integers in the range of 1-1000 or so, whereas we deal less well in comparing the difference between very large numbers (millions and billions and trillions) or between very small ones (small decimal fractions.) But that, like the rest of this, is just a guess.
Hey Noah, what's the meaningful financial industry term for a million dollars?
"Hey Noah, what's the meaningful financial industry term for a million dollars?"
Rounding error.
hey Ibex: a million is no longer meaningful, it is the new penny -- where have you been. Now a billion still has meaning (still!) and is termed a "yard" as in: the iraq war still costs more than 250 yards a year.
I don't understand why people got all these numbers and stuff anyway.
We was all just fine with our hands and toes before them pointy head ivory ziggurat types got up their 'counting' with marks in clay or knot tying and whatnot.
100 basis points equals one percentage point. It's not that jargony.
I suppose it's because when one talks about reducing a percentage value by a percentage, it's ambiguous whether they mean an absolute change or a relative change. The recent reduction from 3% to 2%, for example, could be called both a 1% reduction (3-2) and a 33% reduction (1-(2/3)). The basis point scale sounds silly, but it removes that ambiguity at least.
Ibex:
A million dollars is a buck. "We dropped three bucks today" means "we lost a million dollars."
A billion dollars is a yard. "We traded two yards this afternoon" means "we bought and/or sold two billion dollars worth of whatever it is we trade this afternoon."
(Why a yard? A billion has three sets of zeros between commas. Three feet is a yard, three sets of zeros is a yard.)
I don't know any slang for a trillion dollars. But if the dollar keeps collapsing at its current pace, we'll need to make some up before too long.
A number of options:
1) Most of us did not properly learn fractions and percentages in sixth grade math.
2) Matt, 25 basis points is NOT 25 percentage points. It is 25/100ths of a percentage point or one quarter of one percentage point. As such, refer to number one above to discern the answer to your question. :-)
Speaking of points, why do economists say "price point" instead of "price"?
publishing an economics article requires padding -- price point is a great way to start doubling your article's length -- much like the obligatory (and overly wordy) literature review that is de rigeur in econ journal papers.
Has anyone ever noticed that we park in driveways... and drive in parkways???
because economists assume that markets clear at a given point in price-quantity space. So demand equals supply at a given price and a given quantity, yielding a point in that space as opposed to a pure price level. Or at least that is my intuition for how it ended up that way.
My mortgage costs me 25 rods every hogshead, and that's the way I likes it!
Thanks, Alex. I more or less understand that, and it makes sense.
Nor is it inconsistent with my suspicion that, like other professions, economists like to use jargon to impress the plebs:
PATIENT: Doctor, I have a mysterious rash!
DOCTOR: Hmm -- you have non-specific dermatitis!
PATIENT: Oh, thank you, doctor!
This has already been answered, looks like, but yeah, saying 25 basis points (or bps, or "bips") is just easier than saying "point 25 percent." Or at least, it's the preferred jargon.
As a journalist with a general audience, it's usually still preferable to write 0.25% for the sake of both brevity and clarity.
wait, strike that-- in the case of the fed lowering rates from 4.5% to 4.25%, you'd have to say basis points, because they didn't lower it 0.25%, they lowered it 0.25 percentage points. so basis points is actually the accurate answer AND the more concise one in that example.
if you're talking about something like a mutual fund expense ratio, though, you're safe with 0.25%. just in case this blog starts talking about mutual fund expense ratios.
Another question seriously - what is meant when it is said that the "fundementals" of the economy are strong? What are the fundementals as opposed to all the negative data?
Another question seriously - what is meant when it is said that the "fundementals" of the economy are strong? What are the fundementals as opposed to all the negative data?
Another question seriously - what is meant when it is said that the "fundementals" of the economy are strong? What are the fundementals as opposed to all the negative data?
Wow, I feel so much more confident telling people that my penis is 1.477641*10^-17 LIGHTYEARS long!
Basis points and percentage are two different types of measurements -- basis points are an absolute measurement (100 basis points = 1 percent) and percentage is a relative measurement.
With basis ponts, we can compare the amount of an absolute difference (the spread) between two sets of relative measurements without regard for the value of the two sets of percentages -- the spread between 10% and 9% is the same as the spread between 5% and 4%, that is 100 basis points. Similarly, when the Fed raises or lowers rates, without basis points we'd have to use different percentatges for the same amount of movement of interest rates depending on whether it was going up or down -- 100 basis points above a 4% rate would be a 25% raise, but the same 100 basis points would be a 20% drop from a 5 % rate.
If we tried to express the difference between two sets of percentages in percents, the same absolute difference (e.g. 100 basis points) is a different percentage of, say 10%-9% (10% of 10%) and 5%-4% (20% of 5%).
If we didn't have basis points, our brains would invent them in order to value and communicate comparisons.
The discussion reminds me of a jury trial in a securities fraud class action, where we on the plaintiff's side always talked about our clients' losses in dollars per share, but the defendants profits in total dollars. We figured the jury wouldn't mind requiring a guy who profited by FIVE MILLION DOLLARS to pay other investors a measly three dollars per share, but they might not be willing to order him to pay fifty million dolllars.
(the case settled before verdict, so we'll never know if the strategy worked).
Hey Noah, what's the meaningful financial industry term for a million dollars? - The Puzzled Ibex
An oldy but goody
(to the tune of "Wildwood Flower")
A man says to God "what's a million years to you?"
God says "it's as a second"
So the man says to God "what's a million dollars to you?"
God says "it's as a penny"
So the man says to God "can I have from you a penny?"
And God says "yes, in a second"
Noah Millman's explanation works fine and is an example of how the human psyche works. We always try to convert quantities into comprehensible 'whole' numbers because the human mind can wrap itself around them easier than ridiculously big numbers or small fractions.
In astronomy, no one uses 'miles' or kilometers' because the distances are so big, so first they used 'parsecs' and when parsecs (a parsec is 93 million miles) got to small they came up with light years. Thus the 'buck' and the 'yard' Mr. Millman refers to.
Per basis points, it's easier for the human mind to wrap itself around '10 basis points' than it is '0.1' per cent, in fact the term 'one per cent' is used for interest 'amounts' because it's easier to think 'one per cent' in the '0.01' , or one hundreth of principal.
when parsecs (a parsec is 93 million miles) got to small they came up with light years
Uh, no. You're thinking of AU. A parsec is actually about 3 light years.
Another question seriously - what is meant when it is said that the "fundementals" of the economy are strong? What are the fundementals as opposed to all the negative data?
Inflation and unemployment, primarily.
It's not a matter of just jargon. Every profession /human activity has a language suited to work in that activity.
Eskimos have a lot of different words for different types of snow because distinguishing between those types of snow is important in cross country travel.
cross country skiers will know what I mean -- it's easy to travel through some types of snow whereas other kinds make for a tiring miserable slog.
Those of us in urban areas who wait for snow plows just refer to it all as "white stuff".
You see the small specialized vocabulary in the military, in the medical profession,etc.
We really need someone who can bring a Spitzer-with-a-hooker spin to economics. Make it sexy and engrossing.
And to answer your question, we like talking about numbers between 1 and 100. Thus 4.8 million dollars, 6.2 billion people, etc.
"Another question seriously - what is meant when it is said that the "fundementals" of the economy are strong? What are the fundementals as opposed to all the negative data?"
Fundamentals contrast with technicals. For instance, if the price of a bond is being driven by fundamentals, that means people are looking at the underlying performance of the issuer, the economic conditions and so on. If it's being driven by technicals, that could be things like fear of price volatility, inclusion/removal from an index, the liquidity position of investors, or people reducing their exposure to an asset class for a variety of reasons.
When it comes to the economy, fundamentals are things like employment, productivity, inflation and so on.
Beause "hundredths" is hard to say. English doesn't do well with all those consonants right up against one another without any room to breathe.
The answers on bps are right on - it's just 1/100 of a percentage point (which is very different from "percent", since percentage points are absolute, not relative). Bond yields are usually reported in bps as well - "the 3 year treasury yield rose 6 bps today."
As a real economist, though, I've never once heard the word "price point." In what context is that used? We talk about prices and quantities. Price point seems a very MBAish kind of term.
As for fundamentals, the earlier response about technicals is right on. For instance, the Thai economy could be fundamentally sound, but investors may pull money out because of problems in neighboring countries and cause a currency crisis. Here, fundamentals refers to real figures, not psychological sentiment. In stock markets, fundamentals (earnings growth, etc.) are contrasted with technicals ("there is a barrier at $100 that oil will not cross", "this is an A-B-A pattern on the stock chart", etc.) If you have a broker who uses technical-sounding terms, rather than fundamentals, know that 99% of us economists would consider him or her a quack.
The problem is that technical factors do drive markets to a certain extent, if only because there are "quacks" playing the markets as well as fundamental investors. So you have to take them into account, especially if you're not able to take a long term view.
Comments closed April 01, 2008.
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Heads in the Sand
Because "25 basis points" is more jargony and arcane than "a quarter of a percent."
Posted by The Puzzled Ibex | March 18, 2008 9:22 AM