LIBOR stands for the London Interbank Offered Rate published by the British Banker’s Association. LIBOR indicates the average rate that a participating institution can obtain unsecured funding for a given period of time in a given currency in the London money market. The rates are calculated based on the trimmed, arithmetic mean of the middle two quartiles of rate submissions from a panel of the largest, most active banks in each currency. In the case of the U.S. LIBOR, the panel consists of fifteen banks. These rates are a benchmark for a wide range of financial instruments including futures, swaps, variable rate mortgages, and even currencies.
The LIBOR represents the rate at which banks lend to one another. Due to some …show more content…
The basic idea is that lending money to the US Treasury is essentially risk-free. While there are various technical restrictions in place, the US Treasury can more or less pay off any US dollar obligation with cash. The value of the cash you receive may be uncertain (due to inflation) but the Treasury has never failed to pay off its obligations and is unlikely to fail in the future.
While an investment in a large bank may not normally appear to carry a great deal of risk, there is always a yield greater than a US T-Bill investment. Typically, the TED spread is between 10 and 50 basis points. An increasing spread, particularly over the “norm” is an indication of an increasing reluctance on the part of banks to lend to one another due to greater perceived credit risk.
Note in the graph how volatile the TED spread has been over the last 3 years. During the financial crisis in 2008, in the aftermath of the Lehman bankruptcy,