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The TED spread is the difference in the spread between the purchase and sale of a United States Treasury bill futures contract and a Eurodollar futures contract. The TED spread focuses on the amount of yield that results from the combination of a purchase and a sale of the two different contracts. Along with being a potentially wise investment move, the TED spread can also serve as an indicator of credit risk.
When first developed, the idea of the TED spread involved calculating the difference between the interest rates in place for a three month Eurodollars futures contract and a US Treasury bills futures contract of the same duration. The LIBOR, or London Inter Bank Offered Rate, served as the medium for making the comparison between the Treasury bills and the Eurodollar bills. Over time, the LIBOR has become more instrumental in understanding the yield of the TED spread, owing to the fact that the Chicago Mercantile Exchange choose to remove T-bill futures from the Exchange.
Understanding the yield that takes place when buying a US Treasury bill futures contract while selling a Eurodollar futures contract (or vice versa) can be helpful for both the investor and for understanding the current relationship between banks. For the investor, the ability to calculate the yield can aid in determining if the set of transactions is a good idea at a given point in time. Where banks are concerned, the TED spread can be an indicator of whether or not current economic conditions are adversely affecting the willingness of banks to lend money to each other.
The TED spread can also be helpful is determining the presence and degree of credit risk involved. While T-bills are generally recognized as being free of risk, the LIBOR rate does take into account the risk involved in lending money to commercial banks. When there is an increase in the TED spread, that can indicate a perception of an increase in the potential for default on the loans. When the spread appears to be decreasing, this can be an indicator that the time to borrow is very good and lenders can anticipate a relatively low amount of defaults.