Understanding the TED Spread
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The TED spread (see here for recent quotes) is the difference between the three-month Treasury Bill interest rate and the three-month LIBOR interest rate, that is, the TED spread measures the degree of riskiness of the bank lending market. Increases or decreases in this spread are viewed by market participants as indicating the degree of problems in the banking system. In this article we will briefly discuss the name (TED) of this measure, exactly what it measures (and how this has changed in recent years), questions about whether it measures exactly what it is supposed to measure and how it has performed during the recent crisis.
The name TED Spread comes from an earlier version that calculated the difference between the three month Treasury futures contract and the three month Eurodollars contract (hence the spread between T and ED).
The basic idea is that lending money to the US Treasury is essentially risk-free. While there are various technical restrictions in place, the US Treasury can more or less pay off any US dollar obligation with cash. The value of the cash you receive may be uncertain (due to inflation) but the Treasury has never failed to pay off its obligations and is unlikely to fail in the future.
The Eurodollar interest rate (or the current LIBOR—for quotes see here) represents the rate at which banks lend to one another. Due to some regulations (reserve requirements) imposed by US banking authorities on US banks, a large market for US Dollar deposits developed outside the US. The Eurodollar market in London became the place where Dollars were traded and the London InterBank Offer Rate (LIBOR) became the benchmark price for Dollar deposits. Today the BBA LIBOR rate is a key reference rate for many loans in the US and elsewhere, including many mortgages.
During normal market conditions banks lend to one another at rates slightly above Treasury Bill rates. There is a modest amount of risk of lending money to a bank, since unlike the US Treasury, banks occasionally go out of business and are unable to repay their loans. But during crises in financial markets, when banks are in great difficulty, the LIBOR rate rises relative to Treasury Bill rates (increasing the TED spread) to reflect the additional risk of lending to banks.
You can calculate the TED spread yourself by using historical 3 month LIBOR rates from the BBA (available here) and 3 month Treasury Bill rates (available, among other places, here at Treasury Bills, secondary market, three month). TED spreads in normal times are between zero and one percent, but during the recent financial market crisis (October 2008) have been over 4%.
But there are some questions about the way the BBA LIBOR is calculated. The BBA essentially conducts a daily survey of banks (see here for some of the details) and there has been suspicion in the market that in the current difficult situation the survey may not be as meaningful as it has been previously (see, for example, here). There is an “uncertainty principle” for much financial and economic data that means that the more attention that markets give to a particular number, the more likely the number does not measure what it was intended to measure. In the case of the BBA LIBOR, market participants expect that the number measures the conditions in the interbank market. But precisely at the time when there are problems in the interbank market (and the LIBOR is on the front page of newspapers and on “bugs” on financial TV channels), there are huge incentives for the banks that participate in the BBA survery to respond in a way that might help their short-run situtation and not reflect actual market conditions.
[My apologies to physicists, especially Werner Heisenberg, for using the phrase uncertainty principle in a way that probably makes no sense to them]