TED spread

Defining TED spread

TED spread is the acronym formed by the T-Bill, which is the short-term U.S. government debt, and the ticker for the Eurodollar futures contract.

Primarily, the TED spread was calculated as the difference between the interest rates for three-month U.S. Treasuries contracts and the three-month Eurodollar contract represented by the LIBOR (London Interbank Offered Rate). Currently, the TED spread is defined as the difference between the interest rates for the three-month U.S. T-bill and the three-month Eurodollars contract as represented by the LIBOR because of the fact that the Chicago Mercantile Exchange dropped T-bill futures.

The TED Spread is usually presented in basis points (bps). To illustrate, if the ED trades at 5.20% and the T-bill rate is 5.00%, it follows that the TED spread equals to 20 bps. The TED spread is not a constant, it varies over time. The historical records show that it has often fluctuated within the range of 10 to 50 bps (0.1% to 0.5%).

TED spread as an indicator

In terms of a general economic aspect the TED spread is used as an indicator for perceived credit risk.  This is due to the nature of its components – T-bills and Eurodollars. T-bills are considered risk-free while LIBOR reflects the credit risk of lending to commercial banks. In good economic conditions banks lend to each other helping money flow to end users represented by businesses and consumers. Bankers generally think that there is no risk to lend on the interbank market, so they charge other banks just a bit more than the going rate for T-bills.  As a result, under such circumstances the liquidity in the general economy is not threatened.

Considering the written above we can say that an increasing TED spread signals that lenders believe the risk of default on interbank loans increases as well. Therefore, interbank lenders demand a higher interest rate, or accept lower returns on safe investments such as T-bills. Contrary, when the risk of bank defaults on the interbank market decreases, so does the TED spread. A rising TED spread often foregoes a downturn in the U.S. stock market, as it indicates that liquidity is being withdrawn.