BizJournals Portfolio
Sep 28 2008 10:02pm EDT

The Problem With the TED Spread

Felix points out a potential issue with relying on the TED spread as measure of financial system distress:

...so long as banks can borrow from the central bank overnight, the TED spread is largely unrelated to their real-world cost of capital. Which doesn't make me an optimist, by any means. But I do think that the TED spread can remain elevated for some time without the world coming to an end.

So to get a cleaner sense of inter-bank distress, economists have been tracking Overnight Index Swap rates. Here's a nice explanation why, from State Street's Dan Peirce:

An overnight indexed swap exchanges a fixed level of interest, the OIS rate, for the amount earned by fed funds over the term of the swap. The counterparties to such a swap bear minimal credit risk, as they simply make payment based on the difference between a fixed rate and a stream of variable rates. With a conventional Libor loan, by contrast, the lender bears the credit risk of the borrower for the entire principal plus the Libor interest.

Treas.Libor.giftreas_ois_spread.gifAnd here is a plot of the OIS rate and the target for the federal funds rate:

ois_ffrt.gifMovements in the OIS rate have tended to anticipate Fed interest rate changes. Since the latest episode of the credit crunch with Lehman's failure and the money market shut-down two weeks ago, the OIS rate has deviated southward from the rate target suggesting -- like other interest rate futures -- that despite a bailout, the Fed will cut soon. 


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