The Treasury bill futures contract is a price-fixing mechanism that locks in a rate on a three-month U.S. Treasury bill with a deferred settlement date. Currently, expiration and delivery dates follow from the cycle of Treasury auctions. That is, each open Treasury bill futures contract is settled by physical delivery of $1 million par of U.S. Treasury bills. Deliverable bills must mature ninety-one days from the first of three allowable delivery days.
The Chicago Mercantile Exchange (CME) schedules quarterly expirations to maximize the supply of deliverable Treasury bills, so that the qualifying population includes old one-year bills and old six-month bills, each having three months of remaining life upon delivery, as well as new-issue ninety-one-day bills.
The Eurodollar futures contract is similar to the Treasury bill futures contract. It too is traded on a quarterly cycle, although expiration days do not correspond to those of the Treasury bill contracts. For Eurodollars, expirations always fall two London business days prior to the third Wednesday of the month. This contract is said to be "cash-settled," meaning that no physical delivery occurs. Instead, one last mark to market is made, where the final settlement price is assigned based on cash market yields, specifically reflecting the London Interbank Offered Rate (LIBOR) for three-month Eurodollar deposits, as quoted by the British Bankers Association.1 Each contract covers a national exposure of $1 million.
Prices of both Eurodollar futures and Treasury bill futures are quoted on the basis of an International Monetary Market (IMM) index, where the associated rate reflected by the price index is found simply by subtracting that price from 100.3 For example, a price of 95.10 reflects an interest rate of 4.90% - a discount rate for the Treasury bill futures but an add-on money market yield for the Eurodollars.
TED SPREAD
The TED spread is the difference between the interest rates on interbank loans and short-term U.S. government debt ("T-bills"). TED is an acronym formed from T-Bill and ED, the ticker symbol for the Eurodollar futures contract.
Initially, the TED spread was the difference between the interest rates for three-month U.S. Treasuries contracts and the three-month Eurodollars contract as represented by the London Interbank Offered Rate (LIBOR). However, since the Chicago Mercantile Exchange dropped T-bill futures, the TED spread is now calculated as the difference between the three-month T-bill interest rate and three-month LIBOR.
One of the attractive aspects of the TED spread is its simplicity. An expectation that the spread will widen justifies buying the spread (i.e., buying Treasury bill futures and selling Eurodollar futures), while an expectation of a narrowing of the differential justifies selling the spread. The appropriate trade proportions are one-to-one.
As we can see that it is an important indicator of how much trust is there between large, international banks, which also makes it a good gauge of how freely capital is flowing through the international banking system.
In general, when the TED spread is high, banks are worried that short-term loans made to other banks won't get repaid. When the TED spread is low, banks are confident that short-term loans made to other banks will be paid back.
It's important for consumers and businesses looking for loans to pay attention to the TED spread, because when the flow of capital between banks is stifled, banks in turn not only cut back on the number of loans they make, their loan products also become more expensive.
So, let say you are the owner of a large American bank that has a presence in most of the major industrialized nations of the world, including London, England. You are sitting on a pile of cash and you are interested in making some profit with that cash via a short-term loan. Specifically, you want to make a loan with a term of 3 months. You have options:
1. You could lend the money to the U.S. government and make a small profit. However, the benefit of lending to the federal government is that the loan would be extremely safe. In other words, the odds that the U.S. government would default on that three-month loan are extremely small. After all, the federal government has the ability and the authority to simply print more U.S. dollars if it needs to. So it's a trade off: the risk is small, but so is the profit. To make a 3-month loan to the U.S. government, you would invest in a 3-month Treasury bill.
2. Alternatively, you could make a 3-month loan to another bank in the London wholesale money market. The loan would be riskier than investing in a U.S. Treasury security, as a commercial or retail bank does not have the ability to print U.S. dollars. Moreover, the 3-month loan you plan to make would not be secured by any collateral. So, again, it's a tradeoff: making a short-term loan in the London wholesale money market is riskier than buying a U.S. Treasury security, but your profit would be larger.
So, let's say the yield on a 3-month Treasury is 0.20%, and the 3-month LIBOR yield is 0.90%. The TED spread is the difference between the two, or 0.70 percentage points (which is the same as 70 basis points.) A TED spread below 50 basis points is a good indication that the global banking system is healthy. Above 50 basis points suggests that banks aren't making short-term loans to each other with confidence.
The 1979-1982 period was one high-volatility time span, when the spread ranged from a high of about 400 basis points to a low of about 100. This episode was associated with the effects of Paul Volcker's monetary policy and the Mexican debt crisis.
Beginning in the early to middle 1990s, the market took trading basic TED spreads a step further. Participants started trading longer-term Treasury notes against strips of Eurodollar futures.6 For example, buying (selling) a two-year term TED would involve buying (selling) a two-year cash Treasury note in the spot market and selling (buying) a two-year Eurodollar futures strip (i.e., a strip composed of eight contracts).
The decision to enter a term TED spread (rather than the traditional TED) is justified by the same kind of interest rate expectations that motivate the traditional TED spread, albeit for a different point on the yield curve.
Long the TED Spread: Buy CBOT T-Note Futures & Sell Eurodollar Pack
Short the TED Spread: Sell CBOT T-Note Futures & Buy Eurodollar Pack
Three Measures of TED Spread
Implied Yield TED - We use stud LIBOR and Eurodollar future rates to find the par coupon rates on a note whose cash flow corresponds to those of the Treasury note. The Treasury note's yield is then subtracted from this par coupon to produce the spread. This spread is not tradeable.
Spread Adjusted TED - This measure of the spread is the no. of the quarterly money market basis points that must be subtracted from the stub LIBOR and the Eurodollar futures rates to set the present values of the treasury notes cash flow equal to its full market price.
Implied Price TED - In this case, the present value of the Treasury note's cash flow is reckoned using the zero coupon prices calculated using stub LIBOR and Eurodollar future rates. The resulting present value is treated as the full price value of the note. When the Treasury note's accrued interest is subtracted from this present value, the net is treated as a market price of a hypothetical note whose yield is higher than that of the Treasury note. The difference in the hypothetical note's yield and the Treasury note's actual yield is the Implied price TED.
What Drives the TED Spread Higher?
A lower yield on the 3-month Treasury bill or a higher yield on the 3-month LIBOR rate, or both.
Increased demand will cause the yield on U.S. Treasuries to decline as institutional and individual investors across the globe move money from riskier investments like stocks and corporate bonds to the safety of U.S. government debt.
The yield on the 3-month LIBOR will move higher when banks that participate in the London wholesale money market think that other banks may have problems paying back their short-term loans. The greater the perceived risk, the higher the rate.
There are several financial and/or economic dynamics involved with what the number represents.
These dynamics or financial relationships are composed of financial factors that include: 1) Federal Reserve Bank decision making
2) Perceived market lending risk on interbank loans
3) Spread or difference between two different interest rates.
Since the Federal Reserve Board assesses and determines the interbank lending interest rates, it is logical to assume some economic analysis and risk assessment is incorporated into the interest rate. Secondly, since economics is not an exact science, there is a fractional factor of perceived and/or subjectively determined market conditions in the interbank lending rate. Third, the difference between government loans and bank loans as measured by the Treasury bill interest rate and the Interbank lending rate illustrates a corresponding difference in risk, where the lower the difference, the lower the risk and vice versa.
Financial analysts, investors, economists, bankers and others refer to the TED spread to assess how the Federal Reserve Board judges commercial health of an economy. This in turn can lead to more conservative or liberal financial decisions based on other important metrics such as GDP growth, the unemployment rate, inflation etc. The latter of these metrics i.e. inflation is also important as the issuance of Government Treasury Bills is also tied to inflation.
Specifically, the higher the interest rate on Treasury Bills, the higher inflation may be due to either 1) oversupply of money within the economy 2) low demand for national securities of low risk and 3) the devaluation of currency, or a combination of all three. When the Treasury Bill side of the TED spread is not considered low risk, the TED spread loses some of its analytical capacity as the interest rate on Treasury bills is used as a stable low risk rate in comparison to the Interbank lending rates. If inflation is high and/or a Government is not well managed and insolvent, the value of the TED spread is diminished.
The TED spread is important because it is a simple and direct way to measure a number of things including how solvent the financial system's institutions i.e. banks are, and the availability of money i.e. liquidity within the economy.
LIBOR-OIS spread
The Libor-OIS is the difference between LIBOR and the overnight indexed swap rate. The spread between the two rates is considered to be a measure of health of the banking system just like TED spread. The OIS is a swap derived from the overnight rate, which is generally fixed by the local central bank. The OIS allows LIBOR banks to borrow at a fixed rate of interest over the same period. In the United States the spread is based on the LIBOR Eurodollar rate and the Federal Reserve's Fed Funds rate. LIBOR is risky in the sense that the lending bank loans cash to the borrowing bank, and the OIS is considered stable as both counterparties only swap the floating rate of interest for the fixed rate of interest. The spread between the two is therefore a measure of how likely borrowing banks will default. This reflects risk premiums in contrast to liquidity premiums. In the United States, the LIBOR-OIS spread generally maintains around 10bps. This changed abruptly, as the spread jumped to a rate of around 50bps in early August 2008 as the financial markets began to price in a higher risk environment. Within months, the Bank of England was forced to rescue Northern Rock from failure. The spread continued to maintain historically high levels as the crisis continued to unfold.
 
Ted Spread Trades
Ted spread trades are very common in various financial markets across the world and almost on regular basis banks and proprietary traders indulge into this trade. The reasons for their inclination towards these trades are:
Need of traders to hedge their treasury interest rate risk as against yield changes
Anticipation by speculators about change in difference between London inter-bank market and the FED Rate
During initial years, traders used to go long treasury bills and go short eurodollar futures. Calculating the respective profit or loss was simple as the spread was determined by subtracting the Treasury rate from the eurodollar future rate. The simplicity was further iterated as the issue date and maturity dates of both securities were the same. Gradually, traders began to make TED spread trades using bonds of longer maturity. Thus arose some complications when calculating the spreads, as yields on short term eurodollar contracts were difficult to be compared with yields of long term bond. Hence there was a dire need of developing a means to equate the terms of the two securities to alleviate the problem arising from the difference in maturity and issue dates.
Illustration: Bloomberg
The Euro Future Strip Hedge function of Bloomberg allows user to work out an implied TED spread based on a strip of Eurodollar futures contracts. This is on the TED screen. This screen takes in a strip of the contracts, already having calculated the number and maturity of contracts equating to the amount and maturity of the selected bond. Using the Eurodollar futures, Bloomberg discounts each of the future cash flows of the bond with the rates implied by each of the futures contracts. Once the present values of the cash-flows are calculated, they are summed to produce an implied price. Once the implied price is calculated we work out the corresponding conventional yield and this is subtracted from the yield implied by the market price of the bond. The resulting yield is the implied yield TED. The screen also calculates two other values, namely the spread adjusted TED and the implied price TED. We consider these later in the article.
Trade Setting -Up at Bloomberg
To explain the methodology of the TED function, let us consider an example with a two year US Treasury, the 3% Treasury maturing in November 2003. Initially the user types:
CT2 <GOVT> TED<GO>
After hitting enter, the user arrives at the TED function screen. This screen has input parameters like bond price, settlement date, face amount and different TED spreads as over-rideable fields. He can also specify the type of futures contract he would want to use as well as the rates for the stub contract and the individual eurodollar futures. Once the different parameters have been set, the system shows matching up the cash flows of the Treasury bond and the eurodollar contract. To do this, Bloomberg takes into account the date of the first cashflow of the Treasury from the settlement date of the trade and discovers the futures contract which this cashflow concurs with. The calculation can be illustrated with Figure 1, the TED screen, and Figure 2, the CSHF function which shows the cashflows of the Treasury bond.
Figure 1: The TED Screen
Figure 2: CSHF Screen
For calculating the TED spread, the user must match up the cash flows of the Treasury bond with the eurodollar futures contracts, whose expiry concurs with the coupon payments.
Figure 2 shows the Bloomberg CSHF screen showing information about the future cashflows of the bond if the settlement date is given. In this case it means for the bond that settles on 26 December 2002, at this value date there are two more cashflows remaining. These coupon payments are scheduled on May 31st 2003 (first) and 30th November 2003 (final coupon and principal payments).
For calculation of TED spread there is a need to use a total of 4 Eurodollar futures contracts. These are the EDZ2 <commodity> to EDU3<Commodity> contracts (Bloomberg tickers for these contracts). These Eurodollar futures are showed on the lower half of the TED screen along with their rates or price, an option is selected by the user.
Calculation methodology
The first step in calculating the Implied Yield TED is to calculate the interpolated discount factors derived from the eurodollar futures shown in figure 3.
Figure 3
For the 31st May cash-flow EDZ2 <comdty> would be used to calculate the March 20th discount factor; and the EDH3 <comdty> would be used to calculate the discount factor for the expiry date 18th June 2003. The stub period, i.e. days remaining to the expiry of the first contract, is (from settlement date of 26 December 2002) found to be 84 days. Therefore the discount factor for 20th March 2003 is given by:
(1+((1.4025/100)*(83/360)))^-1 = 0.99677688 [i]
For calculation of the discount factor from the settlement date (26th December 2002) to 18 June 2003 a strip needs to be created by multiplying [i] with the discount factor associated with the EDH3 <comdty> contract. This would be the contract that begins on 17th March and expires on 18th June. This discount factor would be:
(1+((1.355/100)*(91/360)))^-1 = 0.96586553. [ii]
Multiplying [i] and [ii] will give the stripped discount factor for 18th June, which comes out to be:
0.993374435 [iii]
A log of this will yield -0.006046418.
Now with possession discount factors for the boundary dates, the interpolated discount factor for 31st May can be calculated
Natural logarithm of equation [i] will yield:
-0.003228325.
log of [iii] will come as -0.993374435.
Using
(-0.003228325) + ((75/91)* (-0.006647611)-(-0.003228325))
= -0.006046418
and exp(-0.006046418) = 0.993971825 [iv]
The interpolated discount factor can be obtained for 31st May.
Similarly discount factor for 30th November 2003 can be calculated. Using EDM3 <commodity>, EDU3 <comdty> and the strips calculated in equation [iii], the discount factors for 17 September 2002 could be calculated as
0.989821526 [v]
The discount factor for 17 December 2002 is
0.985784737 [vi]
Using the interpolation method used earlier an interpolated discount factor for 30th November 2003 can be calculated as:
0.986449007 [vii]
Since, the bond pays a semiannual coupon equivalent to 1.5%, using the equation
Future Value x discount factor = Present Value
The present value of the cash-flow on the 31st May can be calculated as:
(0.993971825) * (1.5%) = 1.490957737 [viii]
and for 30th November it would be:
(0.986449007) * (101.5%) = 101.1245742 [ix]
The implied price of the Treasury bond can be found by
which would come out to be as:
1.490957737+101.1245742- (0.214285714)
=101.4012462.
Accordingly the implied street convention yield is 1.474% [x]
The resulting TED spread can be obtained by subtracting yield associated with the market price of treasury i.e. 1.267%, from [x] which comes out to be 0.223%
Hedging
The first page on the TED function screen shows the Eurodollar futures contracts used in calculation of TED spread, and also the number of contracts needed hedge effectively. Once the calculation of implied yield TED has been done, it can be found that how many futures contracts are needed to effect a hedge on the Treasury bond. The formula for doing the same (calculation of Hedge Ratio) is:
The rate used in calculation of the discount factor is the TED spread (Eurodollar future rate). The risk associated with the eurodollar future is a constant 0.25.
Historical TED spread analysis
Sometimes trade in market takes place on the value of the TED rather than the bond or Futures' price. Such a trade requires consideration about how this value has varied historically and whether the current value is to be understood as rich or cheap. High values of TED would imply relatively cheap bonds and low values signify expensive ones. Figure 4 illustrates the same. The screen defaults to the eurodollar-futures contract for the currency of the security used
Figure 4
Analysis of Portfolio TED spread
For applying the analysis for a portfolio of securities, the tickers of each security as well as their positions need to be input. Fixed income asset managers, wanting to hedge their Treasuries with Eurodollar futures may create a portfolio of Treasuries and then generate the report. Once the report is completed, the total number of each of the eurodollar futures needed to complete a total hedge of the whole portfolio, the number of contracts needed for a specific treasury (figure 5), and the respective number of eurodollar futures needed to hedge a specific treasury security would be displayed on PTED.
TED Spread trend for last 3 years
Source: Bloomberg
The TED spread is used as an indicator of credit risk. This is owing to U.S. T-bills being considered risk free, while the LIBOR rate reflecting the credit risk of lending to commercial banks. Also it reflects liquidity and degree to which banks are willing to lend to each other. As the TED spread increases, the risk of default (i.e. counterparty risk) is considered to be increasing, and investors will have a preference for safe investments.
From the chart we can see the TED Spread crossing 400 points in October-2008, signifying the credit crisis that emerged at that time. During the fall of 2008, subprime lending and ill-conceived derivative products brought the international banking system to its knees. The global liquidity crisis was at its peak. Venerable Wall Street banks like Lehman Brothers and Bear Stearns failed. Large banks like Citigroup, Washington Mutual and Wachovia were also in big trouble due to bad investments and low-quality loans. The problem was global, as institutional investors; all over the world had money invested in failed financial products dreamt up by Wall Street hotshots.
As a result, the TED spread hit the roof. On October 10, 2008, the 3-month LIBOR yield was 4.81875%, while the yield on the 3-month Treasury bill was 0.21%, which made the TED spread 4.60875 percentage points, or 460.875 basis points.
By May 21, 2009, the TED spread had dropped to 0.48625 percentage point, or 48.625 basis points, thanks in no small part to substantial and coordinated rescue efforts made by central banks and other government agencies across the industrialized world.
The gradual decrease in the spread along the months hence, signifies regaining of confidence of lenders to lend, a healthy sign on the path of recovery from the financial crisis.
