By: Mohamed Bahaa (Under the supervision of Dr. Stephen S. Everhart)

The banking sector is a major component of any economy, since its health is closely related to the strength of the Banking system. Banks act as intermediaries between surplus and deficit units, and help bring back the saved portions of the “household income” into circulation. As credit markets freeze, so does the whole economy; since the amount of money circulating decreases causing liquidity problems. But how is it possible to know whether banks are willing, or unwilling to lend?

I will be discussing one of the credit market proxies, the TED spread, while examining how is it affected by economic conditions, how it’s used in diagnosing the health of the economy, and how it can signal for favorable asset allocation structures and investment tips.

What is the TED spread?


The Treasury-Eurodollar spread, also known as the TED spread, is the difference between the 3 month London Interbank Offered Rate (LIBOR) and the 3 month Treasury bill rate. This spread is known as the “Premium” added to the Risk Free lending rate (T-Bill in this case) which primarily measures the amount of “perceived risk” in the market. The LIBOR, used in calculating the TED spread, is the average of the interest rates offered in the London Interbank market on a 3-month dollar-denominated loan. The TED spread was initially set up as the difference between a 3 month T-Bill future contract and a 3-Month Eurodollar future contract, and hence the name Treasury Eurodollar spread. (Learning Markets)[1]

Components of the TED Spread Calculation


The Treasury bill rate:

The 3-month T-Bill rate is considered as a risk-free lending rate; which theoretically implies that you would be willing to lend any person (or organization) with a zero default risk (Risk Free credit rating) at this RF rate. In this case, the T-Bill rate is considered as the benchmark on which risk premium is added to, of course, according to the risk involved.[2]

The LIBOR in US $ (Dollar denominated 3 month Eurodollar deposits):

The LIBOR is a reference rate based on the interest rates offered on unsecured interbank loans. This (theoretically) measures the expected risk when banks lend each other.[3] This rate as calculated in the TED spread, is the rate offered on interbank loans denominated in US $.

The Importance of the TED spread


The intermediary role of the bank is what entitles it to being the “stimulator” of any economy. This is because of 2 main reasons. First of all, the money creation process in modern economies does not only rely on minting, or on the central bank, but it relies on the issuance of credit by banks. If for instance an investor wishes to deposit $10,000 for 1 year in exchange for the interest, the bank will receive this $10,000 and lend out a portion of it. If the bank issues a loan of $6,000 from the $10,000 deposit, now the borrower owns $6,000 and the depositor owns $10,000. Hence, the bank was able to “create” $6,000 from issuing a loan. Also By delivering the non-circulating portion of income back into the system, banks are able to “theoretically” increase investments, which will in return increase income, and receive more savings, etc.

When this cycle is obstructed, or a credit freeze takes place, the economy suffers drastically; the money creation process and the growth rate of the economy are both halted.  Credit freeze, is usually caused by evident fears in the market.. During such slowdowns, banks tend to refrain from lending, as a result of their inability, or unwillingness. The TED spread, essentially measures this willingness and/or the ability of banks to lend each other, since by measuring the premium you would get on lending another bank (over the rate at which you would lend the US government) you are implicitly measuring the banks’ expected risk on this transaction (Considering that the notion “the higher the risk, the higher the expected return” is always true). This implies that if the spread (premium) is wide, then banks are requiring higher yields to compensate for the higher expected risk (relative to the T-bills) of lending another bank. In simpler words, the TED spread measures the extent of trust (of repayment) evident in the interbank market, as a bank would demand a higher rate only in cases where there is a high probability of default.

The “extent of trust” mentioned above implicitly embodies the fear existing in the economy as a whole and within the interbank market. Credit spreads tend to widen as financial uneasiness is expected. This helps to pinpoint whether a financial turbulence is on the way, and how serious it is.

The 2007-2008 Financial Crisis, the TED and the Banking Sector


Since the start of the Credit Crunch, August 2007, the United States has incurred losses amounting to $7.5 Trillion which makes it the worst financial crisis since the Great Depression of the 1930.[4] The crisis was initially a result of subprime lending, which was motivated by the eagerness of the “Undeserved Borrowers” or the non-creditworthy borrowers, to finance their homes through mortgages, accompanied by the gluttonous investors expecting higher yields promised on the mortgage securities[5]. The “securitization process” of these “junk” mortgages and loans, which was primarily used to mitigate default risk, had magnified the effect to not only include the mortgage issuers, but the financial institutions responsible for the securitization of the mortgages as well (Such as Bear Sterns, which were to fall later). These “subprime” mortgage backed securities were graded as AAA investment-grade securities considering that they were over collateralized by 150% of their value, which still does not change the fact that they are “Junk” mortgages. These credit enhancement techniques enabled the mortgage issuers to bypass the “default risk” by passing it on to the Investors[6]. Institutions now carrying less liability burdens, mortgage lenders are able once more to repeat the same process without waiting for the mortgage re-payments. Unfortunately, this instrument was misused, and was the major trigger to the unfortunate bankruptcy events of some of the giant financial institutions.

In mid September of this year, the world has witnessed the latest financial “Apocalypse”, starting with the fall of Lehman Brothers, one of the largest financial institutions internationally, as well as the “near death” experience lived by the American Insurance Group. This increased anxiety within the global financial world; if one of the largest and most stable financial institutions in the world collapsed, how would other smaller firms do? As problems and worries elevated, banks started to require a higher premium on loans, and rattled investors started to seek “safe haven” in T-bills. This initially caused a credit freeze, since banks are hesitant to issue loans, while depositors are afraid that the banks could lose their savings. As evident in figure 1, during September, as the uneasiness elevated, the TED spread has jumped to approximately 400 basis points, which is higher than the 300 basis points TED during the 1987 crisis showing in figure 2.

Figure 1[7]


Figure2[8]

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Other Financial Turbulence Indicators in Brief


Even though the TED spread is a comprehensive indicator for credit uneasiness, there are other indicators that can be used to diagnose the health of the economy. I will only be talking about 2 of these indicators; the Chicago Board Options Exchange Volatility Index, measuring the volatility of the equity market, and the LIBOR- Overnight Indexed Swap spread.

The LIBOR – Overnight Indexed Swap Spread

The LIBOR-OIS spread compares between the London Interbank Offered Rate (LIBOR) and the overnight index swap (OIS) rate[9]. This is calculated by subtracting the OIS rate from the 3 month LIBOR rate, and is calculated daily, by the average interest rate paid by institutions that day. [10]

The OIS allow financial institutions to “swap the interest rates they are paying without having to refinance or change the terms of the loans they have taken from other financial institutions”[11]

The LIBOR-OIS spread measures the amount of cash available within the interbank market, and is used by banks to determine interest rates. The larger the spread, the less cash there is available to lend out. This spread is beneficial in pointing out liquidity crisis, and is even more beneficial when used alongside with the TED spread.

Chicago Board Options Exchange Volatility Index (VIX)

The VIX is a leading indicator which shows the “market’s expectation of 30-day volatility”[12], also sometimes referred to as the “investor fear gauge”. The VIX is calculated using real-time option prices, hence reflecting the investors’ expected stock market volatility. It is calculated by the Chicago Board Options Exchange as a weighted “blend of options” on the Standard and Poor’s 500 index[13] .

When financial problems are evident in the market the option prices, and hence the VIX, tend to rise; the more the anxiety, the higher the VIX level.  The VIX is a good indicator for future market expectations, since it is derived from the Options market (which is based on instruments that are sold according to certain anticipations).  The VIX is quoted in percentage points of anticipated market movement throughout the next 30 days. Thus a VIX quote of 20, implies a 20% anticipated change in the market during the next 30 days. One complication is that a high VIX does not necessarily mean that the market will be bearish; the VIX implies a market movement, which could either be a negative or a positive movement. Thus, the VIX is a good utility to be used in order to forecast certain movements in the equity market, and hence, react accordingly.

The New VIX

The CBOE has recently adopted a “more precise” measure of expected market volatility, which is briefly described in the following brief description of the new amendments from the CBOE website:

Details from CBOE.com

Figure 3:The VIX (Blue) and S&P 500 (Red).


[1]http://www.learningmarkets.com/index.php/20081002459/Stocks/Intermarket-Analysis/understanding-the-ted-spread.html

[2] “Risk adjusted” interest rates are calculated according to the risk involved, usually by calculating the Beta (sensitivity) of the asset. If there is a 0% default risk, then you lend at the T-Bill rate (if you consider this as your RF rate). If there is a 20% chance of default, then a market premium is added to the risk free rate as compensation for the amount of risk I would tolerate.

[3] Since the LIBOR usually entails a premium above the Risk Free rate, which implies a certain amount of “expected” risk.

[4] Reference: Commission on Growth and Development Working Paper on The U.S. Subprime Mortgage Crisis: Issues Raised and Lessons Learned, by Dwight M. Jaffe

[5] See Footnote 4

[6] Since it is graded as a AAA investment grade by the credit rating agencies, it was considered as a “good quality” asset.

[7] Figure from Wikipedia/TED Spread

[8] Figure courtesy of financialsight.blogspot.com

[9] Source: LearningMarkets.com

[10] Source: LearningMarkets.com

[11] Source: LearningMarkets.com

[12] Source: Investopedia

[13] Source: CBOE

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