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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:

- Increase.
- Decrease.
- 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.*