SOFR and an Overnight Index Swap are not two competing rates. SOFR is a daily benchmark interest rate published by the Federal Reserve Bank of New York, and an Overnight Index Swap (OIS) is a derivative contract that lets two parties exchange a fixed rate for a floating rate built from that benchmark. When people compare SOFR vs OIS, what they’re really comparing is the underlying reference rate against the instrument that trades exposure to it. One is the input; the other is the product.
That distinction shapes everything downstream: how the floating leg is calculated, how the swap is valued, and why the OIS curve has become the standard discount curve across the US dollar derivatives market since panel-based USD LIBOR settings ceased on June 30, 2023.1Financial Conduct Authority. The US Dollar LIBOR Panel Has Now Ceased
SOFR: The Rate Itself
SOFR, the Secured Overnight Financing Rate, measures the cost of borrowing cash overnight against U.S. Treasury collateral. The New York Fed publishes it each business day, drawing on transaction data from the Treasury repurchase agreement market cleared through the Fixed Income Clearing Corporation.2Federal Reserve Bank of New York. Secured Overnight Financing Rate Data
The daily volume underlying the rate regularly exceeds $2 trillion and has recently surpassed $3 trillion, giving it one of the deepest transaction bases of any global benchmark.3Federal Reserve Bank of St. Louis. Secured Overnight Financing Volume (SOFRVOL) That depth is the point. LIBOR’s collapse traced back partly to how few actual transactions supported it.
Because SOFR is collateralized by Treasuries, it’s effectively a risk-free rate. It doesn’t include a bank credit premium, and it won’t widen when unsecured funding stress hits the banking system. In a flight to quality, SOFR can even fall as investors bid up Treasury collateral, while banks’ actual borrowing costs rise. That gap has kept credit-sensitive alternatives like Ameribor alive for some regional lenders, but regulators and the largest market participants have consistently favored SOFR.
Compounded Averages and the SOFR Index
The daily rate is the raw material. For longer periods, the NY Fed publishes compounded SOFR Averages over rolling 30-, 90-, and 180-calendar-day windows, plus a cumulative SOFR Index that tracks the compounded return on one unit of investment since inception.4Federal Reserve Bank of New York. SOFR Averages and Index Data These averages are used widely in floating-rate notes and other cash products.
The OIS: The Contract Built on SOFR
An Overnight Index Swap is an interest rate swap where one party pays a fixed rate and the other pays a floating rate constructed by compounding overnight index readings. No principal changes hands. On each payment date, the two sides net what they owe and settle the difference. For US dollar OIS, SOFR has replaced the effective federal funds rate as the standard overnight index since the LIBOR transition.
The fixed rate is agreed at trade inception and stays constant. The floating rate is set “in arrears,” meaning it’s built by compounding each business day’s published SOFR reading across the accrual period and isn’t fully known until that period ends.
Day counts and payment frequencies vary with maturity. Shorter swaps commonly pay quarterly or annually on both legs using actual/360. Longer-dated swaps often pay the fixed leg semi-annually on a 30/360 basis while the floating leg continues on actual/360.5CME Group. Pricing and Hedging USD SOFR Interest Rate Swaps with SOFR Futures The floating leg is always actual/360, matching the standard US money market convention.6Federal Reserve Bank of New York. An Updated User’s Guide to SOFR
How the Two Fit Together
SOFR feeds the OIS in two directions. First, it provides the daily readings that compound into the floating leg. Second, the market-observed fixed rates on OIS contracts across maturities are used to build the SOFR OIS curve, which becomes the standard forecast of future SOFR levels and the discount curve for present-value calculations.
At initiation, an OIS is priced so that neither side has an advantage. The fixed rate is set where the present value of the expected fixed payments equals the present value of the expected floating payments. Doing that requires forecasting future SOFR readings and discounting those cash flows back to today. Both tasks use the same SOFR OIS curve, extracted from observed OIS fixed rates across tenors.
This dual role explains why the curve sits at the center of the derivatives market. In mid-2020, CME and LCH switched their clearing houses to SOFR-based discounting and price alignment interest. The SOFR OIS curve is now the discount curve not only for SOFR swaps but for essentially all US dollar cleared derivatives.
Once a swap is in force, its value moves with the curve. If the curve shifts upward after a counterparty locked in a lower fixed rate, that counterparty gains value, because a new swap at today’s market would price the fixed leg higher. Mark-to-market valuations use the current curve to re-project floating cash flows and re-discount everything.
What the OIS Fixed Rate Tells You
The fixed rate on a SOFR OIS embeds the market’s consensus forecast for overnight rates over the swap’s life. A two-year OIS fixed rate below current SOFR implies expected rate cuts; above it, expected hikes. The OIS curve is one of the most watched indicators of monetary policy expectations for that reason.
SOFR doesn’t track the federal funds rate perfectly. It draws from a larger and more diverse pool of repo transactions, and it’s noticeably more volatile, especially at quarter-end and year-end when repo market dynamics shift. The effective federal funds rate trades in a narrower band with less daily noise. That volatility flows through into short-dated SOFR OIS pricing.
Short-maturity OIS fixed rates are widely treated as the best proxy for the US dollar risk-free rate, thanks to SOFR’s Treasury collateral base and the sheer size of the market. Algorithmic and high-frequency trading at the short end keeps bid-ask spreads tight.
Compounding, Lookbacks, and the Timing Problem
Compounding the floating leg means applying each day’s SOFR to the notional, then folding that day’s interest into the base for the next day. Over a quarterly accrual period, roughly 60 to 65 business days of readings compound together. The result runs slightly above a simple average of those readings because of the interest-on-interest effect.
A timing problem shows up in practice. The final SOFR reading in any accrual period isn’t published until the next business day, which would leave counterparties without a payment amount on the day it’s due. Two conventions solve this:
- Lookback. Each day’s interest calculation uses the SOFR reading from a set number of business days earlier. The default is five business days.
- Observation period shift. The entire observation window shifts back by a set number of business days relative to the accrual period. The default is also five business days.
Both give counterparties a few days’ notice of the payment amount. The five-business-day default is set by the 2021 ISDA Interest Rate Derivatives Definitions and applies whenever a confirmation doesn’t specify a different value.7International Swaps and Derivatives Association. Documenting RFR Derivatives Using Different Approaches to Compounding/Averaging Under the 2006 ISDA Definitions The 2021 ISDA Definitions, separate from the ISDA Master Agreement, govern the specific rate calculations, compounding methods, and fallback mechanics for SOFR OIS contracts.
Market Size and Hedging Use
The SOFR OIS market is now the most liquid segment of the US dollar derivatives landscape. In the second half of 2024, roughly $39.3 trillion in SOFR-linked OIS notional traded. About 41% carried a tenor of one year or less, 38% fell between one and five years, and 20% ran beyond five years. Liquidity extends across the curve rather than clustering at one point.
The hedging mechanics are direct. A bank holding SOFR-indexed floating-rate loans might enter an OIS paying fixed and receiving compounded SOFR. The SOFR received on the swap offsets the SOFR received on the loan book, leaving a net fixed-rate position. The spread between the OIS fixed rate and a bank’s actual unsecured funding cost is a live measure of credit and liquidity risk in the financial system, comparable in function to the old TED spread.
Most standardized SOFR OIS trades must be centrally cleared. Under CFTC rules, US dollar OIS referencing SOFR with maturities between seven days and 50 years fall within the mandatory clearing requirement.8eCFR. 17 CFR 50.4 – Classes of Swaps Required to Be Cleared Central counterparties like CME and LCH sit between the two sides, absorb counterparty credit risk, and use the SOFR OIS curve to discount variation margin.
Term SOFR Sits Outside the Derivatives Market
Term SOFR is a separate, forward-looking rate derived from SOFR futures and OIS market pricing. The CME Group administers the most widely used version in one-, three-, six-, and twelve-month tenors.9CME Group. Term SOFR It exists mainly for business loans and credit facilities where the borrower needs to know the rate at the start of each interest period.
The derivatives market does not use Term SOFR. The Alternative Reference Rates Committee has consistently recommended that derivatives reference compounded SOFR in arrears instead. So when the question is SOFR vs OIS in a swap context, the SOFR that matters is the daily overnight rate compounded across the accrual period, not the forward-looking Term SOFR quote a borrower sees on a loan agreement.