TED Spreads, Fed Policy, and Financial Stress (Chapter 15, Part 2)
Book: Fixed Income Securities: Tools for Today’s Markets | Author: Bruce Tuckman & Angel Serrat | ISBN: 978-0-470-89169-8
Previous: LIBOR and Short-Rate Derivatives (Chapter 15, Part 1) | Next: Interest Rate Swaps Valuation (Chapter 16)
The second half of Chapter 15 connects short-rate math to real trading and to the crisis signals that still show up on Bloomberg screens today.
TED Spreads: Treasuries vs. the LIBOR Curve
A TED spread asks: what single spread, subtracted from Eurodollar futures rates, reprices a Treasury bond? Treasuries usually trade below LIBOR, so the spread is positive. You build a base curve from ED contract rates (plus a stub rate for the gap before the first contract), discount each cash flow at ED rate minus spread, and solve for the spread that hits the bond price.
For the 1.75s of March 2012 as of May 2010, the TED spread came to about 50 basis points. The 4.25s nearby were around 53.4 bp. Traders use these to judge whether Treasuries look rich or cheap vs. LIBOR.
The method is widely used but not perfect. Futures rates are not quite forward rates. Partial periods get the wrong segment rate. Date alignment between contracts is sloppy. Practitioners accept the warts because ED futures are liquid and transparent.
Hedging a TED view means shorting the rich Treasury and buying ED futures bucket by bucket. Each bucket DV01 is computed by bumping one futures rate one bp while holding the TED spread fixed, then dividing by $25. Fed fund futures cover stub periods when ED contracts do not fit.
Fed Funds, Futures, and Reading the Fed
Banks trade reserves overnight in the fed funds market. The FOMC sets a target and uses open market operations to keep the effective rate near it. Fed fund futures settle to 100 minus the average effective rate over the month. Each contract hedges a $5 million 30-day deposit with $41.67 per bp.
Hedging partial months takes arithmetic. Inside a month you need one contract per $5mm. For 31-day months you need 31/30 contracts. The hedge ratio drifts as days pass.
The April 2004 application is still a great lesson. Fed funds futures implied the market expected a slow tightening cycle. The FOMC hiked 25 bp at five straight meetings. Markets underpriced every move. Extracting implied hike probabilities from futures is useful but fragile. One futures price gives one probability, not a full distribution. Risk premia matter too.
OIS and LIBOR-OIS as a Stress Barometer
Overnight Index Swaps exchange a fixed rate for compounded fed funds effective. The floating leg replicates rolling cash overnight. OIS dates are flexible and liquid out two to three years.
LIBOR-OIS spread compares three-month LIBOR to three-month OIS (fed funds compounded). Before mid-2007 it averaged about 8 bp in USD. It was the price of locking three-month funding vs. rolling overnight. When credit or liquidity fear rises, banks pay up for term funding and the spread widens.
After Lehman it peaked at 365 bp on October 10, 2008. That chart became the poster child for systemic stress. Post-crisis, OIS discounting replaced LIBOR for swap valuation (Chapter 17).
Case Study: Shorting a TED Spread
Tuckman shorts the 1.75s at a 50 bp TED spread, hedged with ED and FF futures. Over five weeks the TED spread tightens from 50 to 38 bp. P&L tracks the bond DV01 times 12 bp, roughly $218k on $100mm face, plus repo carry. The hedge rolls when EDM0 expires: stub risk shifts to fed fund futures. Messy but realistic.
Closing Thought
Chapter 15 is the bridge between money markets and everything else in the book. Swaps in Chapter 16 assume you already know why LIBOR-OIS blew out. Curve fitting in Chapter 21 assumes you know what ED futures are for. This chapter earns its place.