Treasury – Eurodollar (TED) spreads

Posted: February 7, 2010 in Uncategorized

What is a TED spread?

The TED spread is the difference between the interest rates on interbank loans and short-term U.S. government debt (“T-bills”) [Wikipedia].

That being said, it is a measure of the perception of credit risk in the economy.  In times of turmoil,   institutions would tend to prefer risk-free (US if that is still the case?) over LIBOR [commercial institutions (riskier)].

So, what does the spread look like in times of turmoil?  Is there really a flight to safety in extraordinary situations?

Observing the chart above, I believe that yes there is some flight to safety in extraordinary events.  Look at what happens to the spread when the housing bubble exploded.  With that being said, is the risk always to the upside?  Have we extended our budget to the point that we may be the next to default much like Greece recently?

That spread looks like something I would like to trade but how can I observe it intra-day?  I tend to like CQG’s charting capabilities for the TED spread so I will use their platform for this example.

CME 2 year treasury CQG symbol is TUA?1 and the corresponding hedge that I would use would be the white or red CME eurodollar pack (CQG symbol EDAP1 or EDAP1 respectively).  The problem with trying to chart this is that the CME eurodollar packs are quoted in net change from the previous days settlement prices. To overcome this issue, you could compute the average daily price to use instead with (EDA?1+EDA?2+EDA?3+EDA?4)/4 for the white pack or (EDA?5+EDA?6+EDA?7+EDA?8)/4 for the red pack.  This gives you the daily prices for each pack.   Where is the best location to hedge?  The current 2 year future duration is 1.84 based upon Friday’s settlement and the duration of white pack equals 0.6 while the red pack equals 1.61.  I computed this using the time to expiration for each eurodollar contract then averaging over each pack period.  A method for determining the exact number of contracts to hedge with may be found in Galen Burghardt’ eurodollar handbook.

The duration spreads as of Friday’s settlements may be seen below:

Duraion spreads Pack Duration Contract 2y 3y 5y 0.60 H0 1.65 2.67 3.93 M0 1.40 2.42 3.68 U0 1.16 2.18 3.44 Z0 0.91 1.93 3.19 1.61 H1 0.66 1.68 2.94 M1 0.40 1.42 2.68 U1 0.14 1.16 2.42 Z1 -0.11 0.91 2.17 2.61 H2 -0.36 0.66 1.92 M2 -0.61 0.41 1.67 U2 -0.86 0.16 1.42 Z2 -1.11 -0.09 1.17 3.61 H3 -1.36 -0.34 0.92 M3 -1.61 -0.59 0.67 U3 -1.86 -0.84 0.42 Z3 -2.10 -1.08 0.18 4.61 H4 -2.35 -1.33 -0.07 M4 -2.60 -1.58 -0.32 U4 -2.85 -1.83 -0.57 Z4 -3.10 -2.08 -0.82

Where the duration spread = Treasury future duration (or cash issue) – Eurodollar duration.  Note that (1) a good rule of thumb is that the treasury future duration equals the duration of the cheapest to deliver cash treasury issue into the future and (2) that this trade may be duration neutral but still have considerable yield curve risk that may need to be accounted for in your trading.  A final issue to consider is that this trade depending on how you setup the hedge may have stub exposure (the exposure between the current date and the first eurodollar expiration in your hedge).

Using the 2 year vs. the red pack formula of 0.32*TUA-RED PACK (see above for calculation):

With this being done, look at recent activity!  Greece and Spain are both running into issues in their economies and the credit spread (TED) isn’t widening as it normally does.  Does this mean that the expectation for the US to default is becoming larger as our deficit and increase in treasury issues is on the rise?  Are we no longer considered the standard for the risk-free rate?  If not then who is?

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