Ted Spread Definition Formula Calculations How It Works

TED Spread Definition

The strategy was initially established by trading Treasury bill futures against Eurodollar futures, with the same maturity. Both of the items in this scenario are for short-term interest rates in U.S. dollars. The spread approach is based on the assumption that the three-month rates would move in opposing directions. A situation of falling spread is always an encouragement to investors and vice versa.

Key Takeaways

TED (Treasury-EuroDollar rate) spread refers to the difference between the interest rate on three-month U.S. Treasury bills and the three-month LIBOR.The formula to calculate the spread: Three-month LIBOR rate – Three-month Treasury bill rate. It is expressed in percent or base points.The technical indicator throws insight into the overall level of credit risk in the economy, and entities like banks use this tool to enhance the decision-making process.An increase in the TED spread indicates that the default risk on interbank loans is also increasing and vice versa.

How TED Spread works?

TED spread is disclosing the difference between the interest rate appearing when banks lend to each other for a three-month duration and the interest rate the government offers to the public for their three-month treasury billTreasury BillTreasury Bills (T-Bills) are investment vehicles that allow investors to lend money to the government.read more purchase. It throws insight into the overall level of credit risk in the economyEconomyAn economy comprises individuals, commercial entities, and the government involved in the production, distribution, exchange, and consumption of products and services in a society.read more, investors’ trust and confidence in the financial markets, and the U.S. government. Hence banks and investors use this tool to enhance the decision-making process.

The U.S. Treasury bills generally are of short-term duration and backed by the government; hence they are considered a low-risk investment option. At the same time, LIBOR reflects the credit riskCredit RiskCredit risk is the probability of a loss owing to the borrower’s failure to repay the loan or meet debt obligations. It refers to the possibility that the lender may not receive the debt’s principal and an interest component, resulting in interrupted cash flow and increased cost of collection.read more of lending to commercial banks. An increase in the spread indicates that the default risk on interbank loans is also increasing. Hence, interbank lenders demand higher interest rates and are ready to receive the lower interest rate from government treasury bills. Conversely, if the default riskDefault RiskDefault risk is a form of risk that measures the likelihood of not fulfilling obligations, such as principal or interest repayment, and is determined mathematically based on prior commitments, financial conditions, market conditions, liquidity position, and current obligations, among other factors.read more decreases, the LIBORLIBORLIBOR Rate (London Interbank Offer) is an estimated rate calculated by averaging out the current interest rate charged by prominent central banks in London as a benchmark rate for financial markets domestically and internationally, where it varies on a day-to-day basis inclined to specific market conditions.read more rate and the spread decrease, and investors act accordingly.

The spread value normally moves between 10 bps and 50 bps. According to various scholars, if the spread value crosses 48 bps, it indicates an economic crisis. However, it rarely rises above 100 bps, and it can surge considerably higher in times of economic crisis. For example, the TED value reached a very high rate in the 2008 financial crisisFinancial CrisisThe term “financial crisis” refers to a situation in which the market’s key financial assets experience a sharp decline in market value over a relatively short period of time, or when leading businesses are unable to pay their enormous debt, or when financing institutions face a liquidity crunch and are unable to return money to depositors, all of which cause panic in the capital markets and among investors.read more. In October 2008, it crossed above 400 basis pointsBasis PointsBasis points or BPS is the smallest unit of bonds, notes and other financial instruments. BPS determines the slightest change in interest rate, to be precise. One basis point equals 1/100th part of 1%.read more. The values are discernable from the ted spread chart based on the ted spread Fred data. For example, the current value of the spread as of 21 January 2022 is 0.09%.

Formula & Calculations

The spread calculation is based on the following formula:

Let’s consider an example for better understanding the concept through calculation:

Three-month LIBOR rate is 1.36%Three-month Treasury bill rate is at 0.92%TED spread = 3-month LIBOR rate – 3-month Treasury bill rate
```
 = 1.36% – 0.92%

 =0.44% (Percent)

 =0.0044 (Decimal value)

 =44 bps (Basis point) (1 Basis point is 0.01%)
```

How to Trade TED Spread?

It is challenging to time or beat the market, but there are many technical indicators with which an investor or trader can make good investment decisions and enjoy profits. One such indicator is the TED spread, but no investor should solely depend on it. Since banks are readily deciding to get off LIBOR and use a different rate, it is important to understand how it will affect its importance.

The spread indicator gauge the market and overall economic sentiment. If the yield curveYield CurveA yield curve is a plot of bond yields of a particular issuer on the vertical axis (Y-axis) against various tenors/maturities on the horizontal axis (X-axis). The slope of the yield curve provides an estimate of expected interest rate fluctuations in the future and the level of economic activity. read more steepens, it might indicate the market’s bullish orientation. It signals investors to invest specifically in banks. On the other hand, a flattening yield curve indicates a negative or recessionary trend. Investors should be wary of possible hazards returning to the credit market if the spread rises beyond 0.5 percent.