Let's explore how the floating rate on an OIS is reset in practice. While the floating leg resets daily, there are no daily interest payments for operational efficiency. For example, in SOFR swaps, the standard market convention often involves annual payments for both the fixed and floating legs with payments on the same date, resulting in just one net payment per year. This improves operational efficiency, but introduces a timing issue. The fixed rate payer who receives the floating rate, essentially receives their money later than they would in a daily payment setup. Since interest is usually paid at the end of the interest period, the floating rate should theoretically be paid daily. For instance, if a swap starts today and has annual payments, the first floating payment should technically be made tomorrow based on today's overnight rate fixing. Instead, it won't be made until nearly a year later, which would seem like a disadvantage for the fixed rate payer who misses out on the opportunity to reinvest those daily payments and earn interest on interest. So what's the solution? The answer is to use compounded averaging. Instead of simply taking an arithmetic average of all applicable RFR fixing rates, a compounded average is calculated using the formula on the screen. This formula calculates the compounded average rates over the entire period. Let's break it down. RI refers to the daily rates for each day in the period. For example, if we're using SOFR, this would be the SOFR rate for each specific day. DI represents how many days each rate applies to. If the rate is only for one day, then D equals one, but if it covers a weekend, D would be three. The formula works by multiplying together, indicated by the Greek letter Pi, for product one plus the overnight rate for each day adjusted for how long that rate applies.

This gives us the cumulative rate over the period. The final result is the annualized compounded average rate, which is used to determine how much interest is owed at the end of the period. What's the compounded average effectively means is that instead of receiving tiny interest payments daily, the interest owed by the fixed Rate receiver is added to the notional amount, and the next day's RFR is applied to both the original notional and the accrued interest from the previous day. This way, the fixed rate payer is compensated for the delay in receiving the floating interest payments through interest on interest incorporated into the floating rates used at settlements.