18 April 2008

Demystifying the TED Spread

TED is an acronym for Treasury and EuroDollar.

A Spread is just the difference or 'distance' between one thing and another.

Eurodollars are bank deposits denominated in U.S. dollars but held at locations outside of the U.S. Initially, the term only referred to dollar deposits in London but has been expanded to include dollar deposits at any offshore location. The deposits may be held by the foreign branches of U.S. banks or by non-U.S. banks. Eurodollar deposits may be Eurodollar certificates of deposit or simply Eurodollar time deposits.

T bills are US Treasury debt of short duration are considered to be risk free.

TED Spread = Yield on Eurodollar deposits - Yield on T Bills

The TED Spread is the difference between U.S. Treasury bill yields and yields for Euro dollar deposit contracts of the same maturity, generally three months, from the London Interbank Overnight Rate (LIBOR) market.

The theory is that US dollars held in offshore accounts are not subject to short term market activity and regulations by the Fed. They are a slightly better measure of the short term risk associated with holding dollars that are not US Treasuries.

The TED spread is used as a measure of investor confidence. Remember, for the individual components (T bills and Eurodollar deposits) the higher the yield the higher the perceived risk, the lower the yield the lower the perceived risk.

When the spread is small, investors are not requiring a large amount of additional compensation for the additional risk of deposits. This means the Eurodollar yield is lower, and closer to that of the T Bills.

When the spread is large, investors are demanding a higher yield on Eurodollars as compared to the higher quality of U.S. Treasury bills.

A sudden widening of the TED spread is indicative of a flight to quality and a perception of risk in corporate credit markets.

A rising TED spread at the extreme is thought to foretell a downturn in the U.S. stock market as liquidity is withdrawn from the equity markets. We think this is more of a confirming indication than a bellwether since analysis of the SP after extreme readings using TED alone is mixed. In that sense we would use it much as we would use VIX to indicate a period of high or low volatility and elevated or quiescent risk. Spreads by definition are indicators of risk.

TED Spread Chart on Bloomberg