# Spreads

# Spreads

In economics and finance the term *spread* is used in many different contexts. Generally, a spread involves calculating the difference between two related values. In the context of option contracts, for example, spreads involve the buying and/or selling of options of the same type with various exercise prices and expiry dates. John Hull, in his 2006 book, discusses a number of spreads—bull spreads, bear spreads, box spreads, butterfly spreads, calendar spreads, and diagonal spreads. For example, a bullish vertical spread can be constructed by buying one call option and writing one call option with the same expiry date but a larger exercise price. This is called a spread because it is made up of the same type of option, in this case call options. It is bullish because the investor profits from a rise in the price of the underlying asset and is called vertical because there are two different exercise prices involved. As an example, suppose that for $2 you buy a call with an exercise price of $20 and sell for $1 a call with an exercise price of $30. The cost of this bull strategy is $2 - $1 = $1 and the payoff is $10 if the stock price (at expiration) is greater than $30, zero if the stock price is below $20, and the difference between the stock price and $20 if the stock price is between $20 and $30.

In the context of bonds, the spread between the interest rate on risky corporate bonds and the interest rate on risk-free government bonds, both of the same maturity, is called the risk spread (or risk premium). Bonds with default risk always have a positive risk spread, and there is a positive relation between the risk spread and the risk of default. Moreover, the risk spread is a good measure of general economic activity because it is negatively correlated with the overall growth rate of the economy. For example, when the growth rate of the economy slows, the risk of default increases and the immediate impact is an increase in the risk spread. Because default risk is important to the size of the risk spread, credit rating agencies, such as Standard & Poor’s, provide information on default risk by rating the quality of corporate bonds in term of their probability of default.

The spread also refers to the slope of the yield curve—the difference between long- and short-term interest rates. This spread is referred to as the term spread and describes the term structure of interest rates—the relationship among interest rates on bonds with the same risk of default but different terms to maturity. When the yield curve is upward-sloping (the most typical case), the term spread is positive (the long-term interest rate is above the short-term interest rate); when the yield curve is downward-sloping (referred to as an inverted yield curve), the term spread is negative (the long-term interest rate is below the short-term interest rate); and when the yield curve is flat, the term spread is zero (short- and long-term interest rates are the same). Frederic Mishkin and Apostolos Serletis, in chapter 6 of their 2007 study, discuss the yield curve and the term structure of interest rates.

Early investigations into the risk and term structure of interest rates looked at whether the slope of the yield curve—the spread between long- and short-term interest rates—helps predict future short-term interest rates. Studies, such as those by Robert Shiller and colleagues (1983) and Gregory Mankiw and Lawrence Summers (1984), found that the yield curve does not always help predict future short-term interest rates. Subsequent research, however, using better testing procedures, supports a different view. Studies by Eugene Fama (1984) and John Campbell and Shiller (1987, 1991), for example, show that the spread between long- and short-term interest rates contains useful information about future interest rates over the short run and the long run, but not over the intermediate term.

The slope of the yield curve also contains information about overall economic conditions. In fact, an extensive literature documents the usefulness of the yield curve in predicting future economic activity, such as Arturo Estrella and Gikas Hardouvelis’s 1991 study and Estrella and Mishkin’s 1996 and 1998 studies. However, twenty-first-century monetary policy procedures and globalization may be causing this relationship to loosen. In particular, the Federal Open Market Committee in the United States raised the target federal funds rate in seventeen consecutive meetings from June 2004 to July 2006, from 1 percent to 5.25 percent, but long-term interest rates in the United States declined for most of this period. In fact, long-term interest rates around the world have recently exhibited similar declines despite steady increases in short-term interest rates.

As Tao Wu argues in his 2006 study, the reason longterm interest rates have not been responding during the worldwide round of monetary tightening since the turn of the century is the adoption of an inflation-targeting approach to monetary policy as well as globalization. In particular, inflation targeting by many countries, including Australia, Canada, New Zealand, Sweden, and the United Kingdom, and increased international competition in labor and product markets have contributed to price stability and have put downward pressure on longterm interest rates. This has led to the decoupling of longterm interest rates from short-term interest rates with significant implications for monetary policy. In particular, most central banks use short-term interest rates as their operating instruments, but the effects of monetary policy on economic activity stem from how long-term interest rates respond to short-term interest rates. Hence, a deeper understanding of how inflation targeting and globalization affect the spread between long- and short-term interest rates is needed to evaluate the impact and timing effects of monetary policy.

**SEE ALSO** *Spreads, Bid-Ask; Yield*

## BIBLIOGRAPHY

Campbell, John Y., and Robert J. Shiller. 1987. Cointegration and Tests of the Present Value Models. *Journal of Political Economy* 95 (5): 1062–1088.

Campbell, John Y., and Robert J. Shiller. 1991. Yield Spreads and Interest Rate Movements: A Bird’s Eye View. *Review of Economic Studies* 58 (3): 495–514.

Estrella, Arturo, and Frederic S. Mishkin. 1996. The Yield Curve as a Predictor of U.S. Recessions. Federal Reserve Bank of New York, *Current Issues in Economics and Finance* 2: 1–6.

Estrella, Arturo, and Frederic S. Mishkin. 1998. Predicting U.S. Recessions: Financial Variables as Leading Indicators. *Review of Economics and Statistics* 80 (1): 45–61.

Estrella, Arturo, and Gikas A. Hardouvelis. 1991. The Term Structure as a Predictor of Real Economic Activity. *Journal of Finance* 46 (2): 555–576.

Fama, Eugene. 1984. The Information in the Term Structure. *Journal of Financial Economics* 13 (4): 509–528.

Hull, John C. 2006. *Options, Futures and Other Derivatives*. 6th ed. Upper Saddle River, NJ: Pearson/Prentice Hall.

Mankiw, N. Gregory, and Lawrence H. Summers. 1984. Do Long-Term Interest Rates Overreact to Short-Term Interest Rates? *Brookings Papers on Economic Activity* 1: 223–242.

Mishkin, Frederic S. and Apostolos Serletis. 2007. *The Economics of Money, Banking, and Financial Markets: Third Canadian Edition*. Toronto: Addison Wesley.

Shiller, Robert J., John Y. Campbell, and Kermit L. Schoenholtz. 1983. Forward Rates and Future Policy: Interpreting the Term Structure of Interest Rates. *Brookings Papers on Economic Activity* 1: 173–217.

Wu, Tao. Globalization’s Effect on Interest Rates and the Yield Curve. 2006. Federal Reserve Bank of Dallas, *Economic Letter* 1: 1–8.

*Apostolos Serletis*

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