Short Term Interest Rate Spreads

Market participants often use short-term interest rate spreads to evaluate liquidity and credit risk. A good example is the TED spread, which is a key indicator of perceived liquidity and credit risk. TED is formed from an abbreviation US T-bill (T) and the Libor- based Eurodollar futures contract (ED). An increase in the TED spread indicates higher perceived liquidity and credit risk.

Libor-OIS spread is another popular measure of credit and liquidity risk. The Libor-OIS spread is the difference between the Libor and the overnight indexed swap (OIS) rate. An OIS is an interest rate swap with a periodic floating rate of the swap equal to the geometric average of a daily unsecured overnight rate. The index rate is normally the overnight unsecured lending rate between banks.

The Libor is expected to be replaced by the secured overnight financing rate (SOFR), a measure of the US Treasury repurchase market. The SOFR is a daily volume-weighted index of all qualified repurchase market transactions influenced by demand and supply conditions in secured funding markets.

Editor’s note: Libor is still taught in the curriculum but interest rate swaps on more than $80 trillion in notional debt switched to the SOFR in October 2020.

Zero-spread (Z-spread) is the basis point spread that would need to be added to the default-free spot curve to equate the present value of cash flows to the bond price. It uses the zero-coupon yield curve to calculate spreads, generating a more realistic and effective spread. Each cash flow is discounted by the relevant spot rate for its maturity term.

The Z-spread is used to correctly price a risky bond as it constitutes the investor’s additional risk in the form of credit, liquidity, or option risk. The higher the Z-spread, the riskier the bond.

Question

Suppose that the three-month treasury bill rate increases and the Libor rate remain unchanged. The TED spread will most likely:

1. Increase.
2. Decrease.
3. Remain unchanged.

Solution

The correct answer is B.

$$ \begin{align*} & \text{TED spread} \\ & = \text{Three-month Libor rate} – \text{Three-month Treasury bill rate} \end{align*} $$

Therefore, if the T-bill rate increases and Libor remains the same, the TED spread will decrease.

Reading 28: The Term Structure and Interest Rate Dynamics

LOS 28 (g) Describe short-term interest rate spreads used to gauge economy-wide credit risk and liquidity risk.