What Is a Basis Price?
Basis price is a way of referring to the price of a fixed-income security that references its yield to maturity. It is commonly used in relation to bonds. The basis price is useful to investors because it allows them to easily compare the yields they would enjoy if they purchased the investment and held it until its maturity date.
The basis price implicitly assumes that the investor would reinvest all interest payments and earn a rate of return equal to the yield to maturity. Assuming that this interest is continually reinvested and that the bondholder does not sell the bond prematurely, the bond will eventually yield to maturity and earn the bondholder the full basis price.
The term “basis price” is also used in the commodity futures market, to refer to the difference between the spot price of that commodity and its futures price at a given point in time.
- The basis price is a way of quoting bond prices based on their yield to maturity.
- It captures the annual return expected from the bond if the investor holds it until its maturity date.
- Basis price can help investors compare the return on investment of different fixed-income instruments.
How Basis Prices Work
Basis price is one of many ways to refer to the price of a bond. When shopping for bonds, one of the main considerations that investors look for is the yield of the bond—that is, the annual return on investment generated from holding the bond, based on its interest payments. Since bond prices move in the opposite direction of interest rates, the price of bonds fluctuates based on changes to current interest rates and investors’ expectations of future interest rate changes.
For this reason, a bond with, say, a 4% return would be more valuable if similar bonds available in the marketplace were offering less than 4% interest. Likewise, that same bond would become less valuable if market interest rates were to rise. The basis price lets potential investors know how much they can expect to earn on their investment, should they choose to purchase a given bond or security. For instance, a bond with a yield to maturity of 4% would have a basis price of 4%.
This term is also used in the commodities futures market, to describe the spread between the spot price of a commodity and its futures price as of a particular date. For example, if oil is currently trading locally at $100 per barrel, but has a futures price of $95 per barrel in December, the basis price for oil right now would be said to be $5 over December.
Real World Example of a Basis Price
Investors in the fixed-income market will often compare the basis price of a bond or other fixed-income instrument against its coupon. If the basis price is higher than the coupon rate, this would suggest that the bond is being sold at a discount to its par value. Conversely, if the basis price is lower than the coupon rate, this implies that the bond is being sold at a premium.
For example, consider a bond with a coupon rate of 5% and par value of $100. If an investor purchases this bond, they will receive $5 per year (5% of $100) in interest payments. In theory, the investor can receive their $5 interest payments and reinvest them in a similar bond to earn 5% on their interest. In that scenario, the yield to maturity of the bond would be 5%, since the investor expects to earn 5% each year. The basis price of the bond would therefore also be 5%. If that same bond had a basis price of 5% despite having a coupon rate of less than 5%, then that would imply that the bond in question was being offered at a discount to its par value.