I have seen so many different interpretations of these spreads:
For example: TED spread highlights banking risk / credit risk/ counter party risk
Libor OIS: Credit risk / monkey market risk
Swap Spread: Credit Risk/ liquidity risk
Credit risk shows up on all here.
Can anyone please give a definitive answer on the different interpretations, especially TED as they all seem to overlap to me.
how the spreads are calculated differ but all of them always represent credit risk because that’s what spreads are for (a proxy to measure credit risk and thus risk premium for required return). They also represent what kind of risk.
1. TED Spread = LIBOR - Treasury Bill (short term zero coupon bond issued by US government)
since the spread is on top of T-Bill (risk-free asset), this measures the overall credit risk of the economy (related to economic cycles)
2. LIBOR-OIS = LIBOR - OIS (overnight indexed swaps)
LIBOR is the rate at which banks lend and borrow each other money, usually up to a maturity of 1 year. OIS is a rate which are used for unsecured loans between banks with a duration of only 1 day (overnight). For the sake of simplicity you can say that OIS and 1-day-LIBOR should be almost equal. OIS closely tie to reference rates set by central banks such as Fed and due to how short the maturity is, is considered less risky compared to LIBOR. Since these two rates are tied closely to banks, the LIBOR-OIS spread measures liquidity and risk perception in money market (market of funds with less than 1 year of maturity).
3. Swap Spread = Swap rate - government bond yield (use most recently issued government bond) of the same maturity
Recall that swap rate is the fixed rate of a swap and swaps can be used to hedge against interest rate risks but expose you to counterparty credit risk because swap’s counterparty in general is not the government. Swap rate is mostly determined by the market and overall outlook for the future. Since government bond yield is considered risk-free, swap spread measures counterparty credit risk in general corporate world (swap rate is mostly market-determined, a higher swap rate is therefore considered higher risk perception of the business sector)
Thanks Edbert, very helpful.
Out of interest as Libois OIS so extensively focuses on banking wouldnt that be a better measure of banking risk then TED?
I’m not sure about this, since banking is highly omnipresent and is related to everything in the economy, I guess TED as a proxy measure of banking risk makes some sense. Then again, I’m not certain about what is “banking risk”
here’s what I can find from the CFAI Curriculum:
“Compared with the 10-year swap spread, the TED spread more accurately reflects risk in the banking system, whereas the 10-year swap spread is more often a reflection of differing supply and demand conditions.” (2017 CFA Level II Curriculum Volume 5, page 31)