TED spread
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TED spread is the difference in yields between inter-bank and U.S. Government loans.
Initially, the TED spread was the difference between the interest rate for the three month U.S. Treasuries contract and three month Eurodollars contract as represented by the London Inter Bank Offered Rate (LIBOR). However, since the Chicago Mercantile Exchange dropped the T-bill futures, the TED spread is now calculated as the difference between the three month T-bill interest rate and three month LIBOR. The TED spread is a measure of liquidity and shows the degree to which banks are willing to lend money to one another.
The TED spread can be used as an indicator of credit risk. This is because U.S. T-bills are considered risk free while the LIBOR rate reflects the credit risk of lending to commercial banks. As the TED spread increases, the risk of default (also known as counterparty risk) is considered to be increasing, and investors will have a preference for safe investments. As the spread decreases, the risk of default is considered to be decreasing.[1]
The name originates from the initialism of "T-Bill" and "ED"—the ticker symbol for the Eurodollar futures contract. The size of the spread is usually denominated in basis points (bps), e.g. when T-Bills trade at 5.10% and ED trades at 5.50%, the TED spread is said to trade at 40bps. The value of the TED spread fluctuates over time but is often between 10 and 50 basis points (0.1% and 0.5%). A rising TED spread often foretells a downturn in the U.S. stock market as liquidity is withdrawn.
During 2007, the credit crunch, which many believe was caused by the U.S. subprime mortgage securities meltdown, ballooned the TED spread to a region of 150-200bps. On September 17, 2008, the record set after the Black Monday crash of 1987 was broken as the TED spread exceed 300bps.[2]
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