Sofr averages

What Is SOFR Averages?

SOFR averages are backward-looking, compounded averages of the daily Secured Overnight Financing Rate (SOFR) over specific periods, typically 30, 90, and 180 days. As key financial benchmarks, SOFR averages provide a more stable and less volatile reference rate compared to the daily, overnight SOFR. They are widely used in financial contracts, particularly those with longer tenors, to determine interest rates and payment obligations. Their design aims to smooth out the day-to-day fluctuations inherent in the overnight SOFR, offering market participants a reliable measure of the cost of secured borrowing over a defined term.

History and Origin

The introduction of SOFR averages is deeply intertwined with the global transition away from the London Interbank Offered Rate (LIBOR). LIBOR, once a dominant benchmark, faced criticism due to its susceptibility to manipulation and its reliance on expert judgment rather than actual transactions. In response, global regulators and central banks sought more robust, transaction-based alternatives. The Secured Overnight Financing Rate (SOFR) was identified by the Alternative Reference Rates Committee (ARRC), convened by the Federal Reserve Board and the Federal Reserve Bank of New York (NY Fed), as its preferred alternative to U.S. dollar LIBOR.⁹

While the daily SOFR is a robust, transaction-based risk-free rate, its inherent overnight nature meant it could exhibit volatility. To address this, and to provide a rate that more closely resembled the term structure prevalent with LIBOR, the NY Fed began publishing SOFR averages and a SOFR index on March 2, 2020. This development was crucial in facilitating the broader market’s adoption of SOFR-based products by offering backward-looking term rates. The final cessation of most LIBOR settings, including key USD LIBOR tenors, occurred on June 30, 2023, with all remaining synthetic LIBOR settings ceasing on September 30, 2024. T⁸he availability of SOFR averages greatly aided this complex transition, ensuring continuity and stability in financial markets.

Key Takeaways

SOFR averages are backward-looking, compounded averages of the daily Secured Overnight Financing Rate (SOFR).
They provide a more stable reference rate than daily SOFR, smoothing out overnight fluctuations.
SOFR averages are crucial for pricing longer-term financial products and contracts.
Their introduction facilitated the global transition away from LIBOR by offering a term rate alternative.
They are published daily by the Federal Reserve Bank of New York for 30, 90, and 180 calendar-day periods.

Formula and Calculation

SOFR averages are calculated by geometrically compounding the daily SOFR over a specified period. The calculation methodology accounts for weekends and holidays, ensuring that the daily SOFR for non-business days is equal to the rate on the preceding business day. The compounded average is calculated as follows:

\text{SOFR Average} = \left( \prod_{i=1}^{N} \left(1 + \frac{\text{SOFR}_i \times \text{n}_i}{360}\right) - 1 \right) \times \frac{360}{\text{N}_{\text{actual}}}

Where:

(\text{SOFR}_i) = The daily Secured Overnight Financing Rate on day (i).
(\text{n}_i) = The number of calendar days to which (\text{SOFR}_i) applies (e.g., 1 for a weekday, 3 for a Friday before a weekend).
(N) = The total number of business days in the averaging period.
(\text{N}_{\text{actual}}) = The actual number of calendar days in the averaging period (e.g., 30, 90, or 180).
The division by 360 reflects the "Actual/360" day count convention commonly used in money markets.

The Federal Reserve Bank of New York publishes these compounded SOFR averages daily, along with a SOFR Index, which measures the cumulative effect of compounding SOFR over time. T⁷his index allows for the calculation of custom compounded SOFR averages over any desired period.

Interpreting the SOFR Averages

SOFR averages are interpreted as a robust measure of the average cost of overnight collateralized borrowing over a specific tenor. Unlike the single-day, spot nature of the daily Secured Overnight Financing Rate, the averages provide a smoothed, more predictable rate. For financial professionals, a rising SOFR average generally indicates an increase in short-term funding costs, while a declining average suggests the opposite.

These averages are backward-looking, meaning the rate for a given period (e.g., a 30-day SOFR average) is only fully known at the end of that period, as it incorporates all daily SOFR rates within that window. This characteristic is particularly relevant for financial instruments that reference SOFR averages, as it dictates when interest payments can be precisely determined. Market participants utilize these rates to gauge overall liquidity and funding conditions in the repurchase agreements market, providing insights into the short end of the yield curve.

Hypothetical Example

Consider a one-year floating-rate loan with quarterly interest payments, where the interest rate is set as the 90-day SOFR average plus a spread of 1.5%. For the first quarter (e.g., January 1 to March 31), the interest rate will be determined by the 90-day SOFR average calculated from daily SOFR readings between January 1 and March 31.

Let’s assume:

On March 31, the published 90-day SOFR average for the preceding 90 days is 5.00%.
The loan principal is $1,000,000.

The interest rate for the first quarter would be 5.00% (90-day SOFR average) + 1.50% (spread) = 6.50%.

The quarterly interest payment would be calculated as:
(\text{Interest Payment} = \text{Principal} \times \text{Annual Rate} \times \frac{\text{Days in Quarter}}{360})
(\text{Interest Payment} = $1,000,000 \times 0.0650 \times \frac{90}{360} = $16,250)

This payment is determined at the end of the quarter, after all daily SOFR rates for the period have been observed and averaged. This contrasts with forward-looking rates, which are known at the beginning of the interest period.

Practical Applications

SOFR averages play a vital role across various segments of the financial industry, particularly in the post-LIBOR era. Their primary application is in the pricing of floating-rate loans, bonds, and derivatives. For instance, many corporate loans and securitized products now reference SOFR averages, providing a stable, transaction-based benchmark for their variable interest components.

In the hedging market, SOFR averages are crucial for calculating payments on interest rate swaps, which are used by institutions to manage their exposure to interest rate fluctuations. Financial institutions also use SOFR averages in their internal transfer pricing and funds management, aligning their cost of funds with the new market benchmark. Additionally, regulators and market participants utilize the published SOFR averages to monitor broad funding costs and market conditions, providing a transparent and robust reference for assessing financial stability. The Federal Reserve Bank of New York publishes these averages, ensuring their accessibility and consistency across the market.

##⁶ Limitations and Criticisms

While SOFR averages offer significant improvements in transparency and robustness compared to LIBOR, they are not without limitations. A primary criticism is their lack of a "credit-sensitive" component. LIBOR inherently incorporated a bank credit risk premium, meaning it tended to rise during periods of financial stress as banks' perceived borrowing costs increased. In contrast, SOFR, being a collateralized rate based on repurchase agreements backed by U.S. Treasuries, reflects a near risk-free rate. This distinction means that during market dislocations, SOFR may decline as investors flock to safe assets like Treasuries, even as banks' own unsecured funding costs are rising. This divergence can create asset-liability mismatches for lenders, potentially straining profitability during stress periods and leading to calls for alternative credit-sensitive rates.

An⁵other point of discussion revolves around the volatility of the underlying daily SOFR, which SOFR averages are designed to mitigate. While averaging reduces this, the backward-looking nature means that the precise interest payment for a period is only known at the end of that period, complicating cash flow forecasting for some borrowers. Thi⁴s contrasts with the forward-looking nature of traditional LIBOR tenors, which were fixed at the beginning of the interest period. Despite these considerations, the broad market adoption of SOFR averages is a testament to their utility as a transparent and reliable benchmark.

SOFR Averages vs. Term SOFR

SOFR averages and Term SOFR are both derived from the Secured Overnight Financing Rate but serve different purposes due to their distinct methodologies:

Feature	SOFR Averages	Term SOFR
Nature	Backward-looking	Forward-looking
Calculation	Compounded average of past daily SOFR rates	Derived from SOFR derivatives (futures) market
Known When?	At the end of the interest period	At the beginning of the interest period
Volatility	Smoothed, less volatile than daily SOFR	Reflects market expectations, more stable
Primary Use	Interest accrual on floating-rate loans, bonds, and some derivatives	Setting rates for corporate loans, some hedging products, and financial planning
Predictability	Offers certainty for past period	Offers certainty for future period

The fundamental difference lies in their temporal orientation: SOFR averages reflect what has already occurred, providing a historical snapshot of the compounded cost of collateralized overnight borrowing. Term SOFR, conversely, provides a forward-looking rate, akin to how LIBOR functioned, giving market participants an indication of future interest costs at the outset of a financing period. This makes Term SOFR particularly appealing for corporate lending where borrowers prefer to know their interest obligations in advance.

FAQs

How often are SOFR averages published?

SOFR averages (for 30-, 90-, and 180-calendar day periods) are published each business day by the Federal Reserve Bank of New York shortly after the daily SOFR is published. Thi³s regular publication ensures that market participants have access to timely and consistent data for their financial contracts.

Why were SOFR averages created?

SOFR averages were created to address the need for a stable, term-like reference rate to replace LIBOR. While the daily SOFR is a robust overnight rate, its inherent volatility made it less suitable for many longer-term financial products. The averages smooth out these daily fluctuations, providing a more practical and predictable benchmark for loans, bonds, and derivatives with longer interest periods.

##²# Are SOFR averages risk-free?
SOFR averages are considered near risk-free rate because they are based on transactions in the U.S. Treasury repurchase agreements market, which are collateralized by highly liquid U.S. government securities. This means they do not incorporate the credit risk component that was present in LIBOR, which reflected unsecured interbank lending.¹