x Abu Dhabi, UAEWednesday 26 July 2017

Getting right to the point

The basis point is, for the most part, one of the most frivolous pieces of financial lingo out there.

The basis point is, for the most part, one of the most frivolous pieces of financial lingo out there. It can provide a useful distinction between absolute and relative movements in interest rates; more often than not, though, it's used for self-aggrandisement or to cause confusion. Shills who want to sell you investments like to use it in a subtle effort to sound like they know what they're talking about. Sometimes they do, but just as often they're merely trying to sound sophisticated.

So what is it? A basis point is short for one hundredth of a percentage point, or 0.01 percentage points. One percentage point equals 100 basis points. Five percentage points is 500 basis points. And 0.25 of a percentage point is 25 basis points. Why people can't simply say "five percentage points" or "half a percentage point" is an enduring mystery, although the term can help distinguish between movement in percentage points versus a percentage movement. In other words, if an interest rate goes from 10 per cent to 10.75 per cent, saying it moved 75 basis points is correct; saying it moved up 0.75 per cent is not. (It moved up 7.5 per cent.)

You'll find basis points thrown around in a couple of main areas. When central banks raise or lower interest rates, the amount by which they do their raising and lowering is often described using the term. "The [European Central Bank] cut its benchmark rate by 75 basis points to 2.5 per cent, the biggest cut in its 10-year history," said an Associated Press article last month. Translation: the ECB cut its rate by 0.75 of a percentage point, from 3.25 per cent to 2.5 per cent.

You'll also hear about basis points when investment returns and expenses get quoted. If a financial adviser wants you to buy shares in a mutual fund, for example, he might say it outperformed its benchmark index "by 50 basis points" last year. That, after all, sounds a lot more impressive than saying a fund beat the index by 0.5 per cent. The term makes a bit more sense as shorthand when talking about annual mutual fund expenses, where it is also in wide use. If one fund charges 1.43 per cent per year and another charges 1.57, it's somewhat useful to say the latter costs 14 basis points more per year. That formulation flows better than the awkward "0.14 of a percentage point more expensive."

For the same reason, basis points provide a useful shorthand when discussing minuscule differences between bond yields. In the end, though, it is probably wise to be suspicious whenever basis points (or the abbreviation bp) come up. @Email:afitch@thenational.ae