What is the difference between term SOFR and overnight SOFR, and when should each be used in financial contracts?

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.\n\nHow Each Rate Is Determined:\n\n| Feature | Overnight SOFR | Term SOFR |\n|---|---|---|\n| Publisher | NY Fed | CME Group |\n| Nature | Backward-looking realized rate | Forward-looking term rate |\n| Tenor | One day | 1M, 3M, 6M, 12M |\n| Derived from | ~$1 trillion daily repo transactions | SOFR futures (1M and 3M) |\n| Known when? | Next business day (T+1) | Beginning of interest period |\n| Compounding needed? | Yes, over the accrual period | No, rate is set upfront |\n\n`mermaid\ngraph TD\n A[\"SOFR Ecosystem\"] --> B[\"Overnight SOFR
NY Fed publishes daily\"]\n A --> C[\"Term SOFR
CME derives from futures\"]\n B --> D[\"Used in:
- Derivatives (ISDA protocol)
- Floating-rate notes
- Interbank markets\"]\n C --> E[\"Used in:
- Business loans
- Trade finance
- Mortgages
- Securitizations\"]\n B --> F[\"Compounded in arrears
Payment amount unknown
until near period end\"]\n C --> G[\"Known at period start
Borrower can budget
cash flows in advance\"]\n`\n\nWorked Example:\nPinnacle Manufacturing takes a $20 million floating-rate loan referencing 3-month term SOFR plus 185 basis points.\n\nOn January 15, the 3-month term SOFR fixes at 4.28%. The interest rate for the January 15 to April 15 period is:\n\n4.28% + 1.85% = 6.13%\n\nInterest payment = $20M x 6.13% x (90/360) = $306,500\n\nThe 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).\n\nARRC Recommendations:\n\nThe Alternative Reference Rates Committee (ARRC) recommends:\n- Derivatives: Overnight SOFR compounded in arrears (aligns with ISDA fallback protocol)\n- Business loans: Term SOFR is acceptable; overnight SOFR compounded in arrears also works\n- Consumer products: Term SOFR preferred for operational simplicity\n- Securitizations: Both are used; term SOFR dominates new issuance\n\nWhy the Distinction Matters for Risk Managers:\n\nTerm 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.\n\nMaster benchmark rate mechanics in our FRM Part I materials.