What is the difference between term SOFR and overnight SOFR, and when should each be used in financial contracts?
I'm studying the LIBOR transition for FRM and I see references to both 'overnight SOFR' and 'term SOFR.' They both seem to be SOFR, so what's the distinction? My understanding is that SOFR is an overnight rate, so how can there be a 'term' version? And which one actually gets used in loan agreements vs. derivatives?
Overnight SOFR and term SOFR serve different purposes in the post-LIBOR landscape. Overnight SOFR is the actual daily rate published by the Federal Reserve Bank of New York, while term SOFR is a forward-looking rate for defined periods (1M, 3M, 6M) published by CME Group, derived from SOFR futures prices.
How Each Rate Is Determined:
| Feature | Overnight SOFR | Term SOFR |
|---|---|---|
| Publisher | NY Fed | CME Group |
| Nature | Backward-looking realized rate | Forward-looking term rate |
| Tenor | One day | 1M, 3M, 6M, 12M |
| Derived from | ~$1 trillion daily repo transactions | SOFR futures (1M and 3M) |
On January 15, the 3-month term SOFR fixes at 4.28%. The interest rate for the January 15 to April 15 period is:
4.28% + 1.85% = 6.13%
Interest payment = 306,500**
The borrower knows this amount on January 15 and can plan accordingly. Had the loan referenced overnight SOFR compounded in arrears, the exact payment would not be known until approximately April 13 (two business days before payment).
ARRC Recommendations:
The Alternative Reference Rates Committee (ARRC) recommends:
- Derivatives: Overnight SOFR compounded in arrears (aligns with ISDA fallback protocol)
- Business loans: Term SOFR is acceptable; overnight SOFR compounded in arrears also works
- Consumer products: Term SOFR preferred for operational simplicity
- Securitizations: Both are used; term SOFR dominates new issuance
Why the Distinction Matters for Risk Managers:
Term SOFR embeds a small term premium above compounded overnight SOFR (typically 2-8 basis points for 3-month tenor). This basis between the two rates creates a new source of basis risk that must be managed in hedging programs using both rates. A loan referencing term SOFR hedged with a swap referencing overnight SOFR will have residual basis exposure.
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