Fed Rate or SOFR?

07/26/2024|Business Valuation CPA|

The Fed rate (Federal Funds Rate) and the Secured Overnight Financing Rate (SOFR) are related but distinct interest rates used in the U.S. financial system. Here’s a breakdown of each:

Federal Funds Rate

  • Definition: The interest rate at which depository institutions (banks and credit unions) lend reserve balances to other depository institutions overnight on an uncollateralized basis.
  • Set By: The Federal Reserve (the Fed).
  • Purpose: Used to influence overall monetary policy, control inflation, and stabilize the economy.
  • Usage: A benchmark for various other interest rates, including rates on loans, mortgages, and savings.

Secured Overnight Financing Rate (SOFR)

  • Definition: A broad measure of the cost of borrowing cash overnight collateralized by Treasury securities.
  • Set By: Derived from actual transaction data in the Treasury repurchase (repo) market.
  • Purpose: A risk-free reference rate intended to replace the London Interbank Offered Rate (LIBOR) in many financial contracts.
  • Usage: Used as a benchmark for derivatives and financial products.

Key Differences

  1. Nature: The Fed rate is unsecured, while SOFR is secured by Treasury securities.
  2. Setting Mechanism: The Fed rate is a target rate set by the Federal Reserve, whereas SOFR is based on actual transaction data in the repo market.
  3. Usage: The Fed rate influences broader monetary policy and other interest rates, while SOFR serves as a benchmark for pricing loans and derivatives, particularly after the phasing out of LIBOR.

Relationship

While both rates are integral to the financial system, they serve different purposes and are calculated differently. The Fed rate can influence SOFR indirectly as changes in the Fed rate can affect market interest rates, including those in the repo market.