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TED Spread

TED Spread
InvestingBondsTreasury Bonds

What Is the TED Spread?

The TED spread is the difference between the three-month Treasury bill and the three-month LIBOR situated in U.S. dollars. To put it another way, the TED spread is the difference between the interest rate on short-term U.S. government debt and the interest rate on interbank loans.

TED is an abbreviation for the Treasury-EuroDollar rate.

Understanding the Ted Spread

The TED spread was initially calculated as the price difference between three-month futures contracts on U.S. Treasuries and three-month contracts for Eurodollars with identical expiration months. After futures on Treasury bills (T-bills) were dropped by the Chicago Mercantile Exchange (CME) following the 1987 stock market crash, the TED spread was amended. It is calculated as the difference between the interest rate banks can loan to one another north of a three-month time outline and the interest rate at which the government can borrow money for a three-month period.

The TED spread is utilized as an indicator of credit risk. This is on the grounds that U.S. T-bills are viewed as risk free and measure a ultra-safe bet — the U.S. government's creditworthiness. In addition, the LIBOR is a dollar-denominated check used to reflect the credit ratings of corporate borrowers or the credit risk that large international banks expect when they loan money to one another. By contrasting the risk-free rate to some other interest rate, an analyst can determine the perceived difference in risk. Following this construct, the TED spread can be understood as the difference between the interest rate that investors demand from the government for investing in short-term Treasuries and the interest rate that investors charge large banks.

As indicated by an announcement by the Federal Reserve on November 30, 2020, banks ought to stop writing contracts utilizing LIBOR toward the finish of 2021. The Intercontinental Exchange, the authority responsible for LIBOR, will stop distributing multi week and two month LIBOR after December 31, 2021. All contracts utilizing LIBOR must be wrapped up by June 30, 2023.

As the TED spread increases, the default risk on interbank loans is viewed as expanding. Interbank lenders will demand a higher rate of interest or will actually want to accept lower returns on safe investments, for example, T-bills. In other words, the higher the liquidity or solvency risk presented by at least one banks, the higher the rate lenders or investors will expect on their loans to other banks compared to loans to the government. As the spread abatements, the default risk is viewed as decreasing. In this case, investors will sell T-bills and reinvest the proceeds in the stock market which is perceived to offer a better rate of return on investments.

Calculation and Example of the TED Spread

The TED spread is a relatively simple calculation:

TED Spread = 3-month LIBOR - 3-month T-bill rate

Of course, it is far simpler to let the St. Louis Fed calculate and chart it for you.

Typically, the size of the spread is designated in basis points (bps). For instance, if the T-bill rate is 1.43% and LIBOR is 1.79%, the TED spread is 36 bps. The TED spread fluctuates after some time but generally has stayed within the scope of 10 and 50 bps. Notwithstanding, this spread can increase over a more extensive territory during times of crisis in the economy.

For instance, following the collapse of Lehman Brothers in 2008, the TED spread topped at 450 basis points. A downturn in the economy indicates to banks that other banks might encounter solvency issues, leading banks to restrict interbank lending. This, thusly, prompts a more extensive TED spread and lower credit availability for individual and corporate borrowers in the economy.

Highlights

  • The TED spread often extends in periods of economic crisis, as the default risk broadens; the spread river when the economy is more stable and defaults are to a lesser degree a risk.
  • The TED spread is normally utilized as a measure of credit risk, as U.S. Treasury bills are viewed as risk-free.
  • The TED spread is the difference between the three-month LIBOR and the three-month Treasury bill rate.