Understanding the TED spread

One measure that is being used to summarize the strain in financial markets is the TED spread. This is calculated as the gap between 3-month LIBOR (an average of interest rates offered in the London interbank market for 3-month dollar-denominated loans) and the 3-month Treasury bill rate. The size of this gap presumably reflects some sort of risk or liquidity premium. I was interested to break the TED spread down into identifiable components to try to get a better understanding of what may be responsible for its recent behavior.

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One can break the TED spread down into separate components using the following accounting identity. Let LIBOR3 denote the 3-month LIBOR rate, LIBOR0 the overnight rate, TARGET the fed funds target, and TBILL the 3-month Treasury bill rate. The TED spread is defined as

TED = (LIBOR3 - TBILL)

which can be rewritten as

(LIBOR3 - TBILL) = (LIBOR3 - LIBOR0) + 
    (LIBOR0 - TARGET) + 
    (TARGET - TBILL)

NPR on the TED spread

The TED spread is at the epicenter of the storm.

Metafilter 2008-10-14

Bloomberg rates

• Bloomberg 3-month LIBOR quote
• Bloomberg TED spread quote
  Watch the TED spread to see the state of the crisis. You're looking for lower numbers, preferably below 50 to 100 basis points.

2008-10-14: The 3-month yield was only 12 basis points. This is phenomenally low, indicating a great deal of fear in the market.

I'm going to be keeping my money out of the market until the TED spread returns to a more normal rate, like 50 to 100 basis points.