It should be emphasized that this d

It should be emphasized that this discussion uses the terms “asset” and “liability” loosely and not in any strict accounting sense. We include among assets and liabilities both derivatives and other instruments that may behave like assets or liabilities. A pay fixed interest rate swap might be considered a combination of a floating rate asset with a fixed rate liability. On a stand alone basis, it poses considerable term structure risk.

Basis risk is a component of interest rate risk due to possible changes in spreads. In fixed income markets, basis risk arises form changes in the relationship between interest rates for different mar-ket sectors. If a bank makes loans at prime while financing those loans at Libor, it is exposed to the risk that the spread between prime and Libor may narrow. If a portfolio holds junk bonds hedged with short Treasury futures, it is exposed to basis risk due to possible changes in the yield spread of junk bonds over Treasuries. Basis risk is another name for spread risk.