Lesson 6 of 25 · 7 min
What a spread is compensating for
Strip out everything the index already tracks and what remains includes a wedge that widens exactly when funding is hardest.
Track 8 lesson 16 broke a spread into its cost components. This lesson asks a narrower question: why does the spread exist as a separate leg at all, instead of being folded into one quoted number?
Because the two legs answer different questions. The index answers what money costs in one market on one day. The spread answers everything that market does not describe, including the difference between what the index says money costs and what this lender actually pays for it.
That difference is the funding basis. In calm conditions it sits in the lender's favour: an illustrative index at 4.40 percent against a blended funding cost of 4.12 leaves a wedge of 0.28 of a point. In stress the two decouple, because the cheap balances that made the blend cheap are the first to leave. An index at 4.55 against a funding cost of 5.18 leaves a wedge of 0.63 the other way. Between those states the lender's realised margin on an unchanged 1.95 percent spread moved 0.91 of a point.
So a spread is partly compensating for a risk with nothing to do with the borrower: the risk that the index stops describing the lender's own cost of money. The index leg is a pass-through only while the basis is stable, and when it is not, the spread is the only leg in which a correction can be made.
A spread is a residual after one market has absorbed what it can, and residuals are where the surprises live. Widening one does not require anything to have changed about the borrower.
For a pledged portfolio the timing matters most. Funding bases widen in conditions that also push collateral prices down, so a spread revision is not randomly placed with respect to your headroom; it tends to land in the same quarter as a drawdown.
Key terms
- Funding basis
- The gap between the index a loan is priced on and what the lender actually pays for money. Usually small, and unstable in stress.
- Blended funding cost
- The weighted average price a lender pays across all its sources of money. Rises when cheap balances are replaced by expensive ones.
- Realised margin
- What the lender actually earns after its own funding cost, as opposed to the spread it quoted. The two are equal only when the basis is zero.
Worked example
The same spread, two very different margins
One facility at a 1.95 percent spread, observed in a calm month and a stressed one. Illustrative figures.
- Calm month: index and funding cost
- 4.40% and 4.12%
- Realised margin that month
- 2.23 points
- Stressed month: index and funding cost
- 4.55% and 5.18%
- Realised margin that month
- 1.32 points
- Swing in realised margin
- 0.91 of a point
- Spread revised to 2.55%, annual cost on $1,720,000
- $10,320
A basis of +0.28 in the lender's favour.
1.95 + 0.28.
A basis of −0.63.
1.95 − 0.63.
The quoted spread was unchanged throughout.
$1,720,000 × 0.0060.
The lender's economics moved 0.91 of a point before anything was repriced. The 0.60 revision that followed was a correction to a leg that had already failed, not a new judgement about the borrower.
Check yourself
The index is 3.95 percent, the lender's blended funding cost is 4.46 percent, and the quoted spread is 1.80 percent. What does the borrower pay, and what does the lender earn?
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Educational only. Nothing in this lesson is investment, legal or tax advice, or a recommendation to enter into any transaction. Figures are illustrative and computed from the inputs stated in the lesson.