In simple terms, the TED spread is the difference between the interest rates offered by the US government and the banks on money lent by an investor. It indicates the risks associated with lending to commercial banks vis-à-vis lending to the USgovernment.
TED is the shortened form of T-bill and ED (the ticker for the Eurodollar futures contract). Initially, the TED spread was thedifference between the interest rates offered by the three-month US Treasuries and the three-month Eurodollar contracts. With thescrapping of the trading of T-bill futures by the Chicago Mercantile Exchange (CME), the TED spread now focuses on T-bills and LIBOR.
The value of the TED spread, measured in basis points or bps, fluctuates continuously to reflect credit risks in the generaleconomy. Historically, the TED spread has averaged between 30 bps and 50 bps. However, the subprime mortgage crisis of 2007 andthe subsequent financial crisis of 2008 resulted in a ballooning of the TED spread, which finally reached a new historical high of 465 bps on October 10, 2008. This enormous increase in the TED spread indicated the collapse of interbank lending and weakened the banking sector.
The TED spread is the basis for calculating credit or default risk of a borrowing bank. A rise in the TED spread reflectslender belief that the risk of a default on interbank loans has increased. Under such circumstances, lenders prefer to invest insafer options, like the US T-bills, which are short term in nature and offer better credit quality. When the possibility of defaults is higher, lending banks also demand greater interest rates for putting their money at risk. With lenders tightening their hold on cash, liquidity issues arise, all of which act as a precursor for a weakening of the stock market.