Risk Management and Control

Market risk arises primarily in UBS’s trading activities, which are mainly in the Investment Bank, with limited activity in the wealth management business to facilitate private client business, and in asset management through investments in support of the alternative and quantitative investments business. Additionally, the Treasury department assumes market risk through its balance sheet and capital management responsibilities.

Conditions were challenging at the beginning of third quarter following the market correction in May and June. Sentiment improved in August as oil prices fell, the outlook for corporate profits improved and inflation fears eased, supported by the pause in interest rate increases by the US Federal Reserve. Market risk for the Investment Bank, as measured by the average 10-day 99% confidence Value at Risk (VaR), increased to CHF 453 million in third quarter 2006 from CHF 408 million in second quarter. VaR was reduced towards the end of the quarter to CHF 398 million, only slightly higher than the previous quarter-end level of CHF 390 million.

Interest rate risk was again the largest contributor to overall Investment Bank VaR, averaging CHF 523 million in third quarter 2006, up from CHF 394 million in second quarter. Quarter-end VaR rose to CHF 484 million from CHF 402 million. Interest rate exposure consists of both exposure to the level and shape of interest rate curves and exposure to credit spreads. In third quarter, as in previous quarters, the dominant component of interest rate VaR was credit spread exposure, but exposures to US dollar and, to a lesser extent, euro interest rates were the primary drivers of the changes in interest rate VaR during the quarter.

Average equities VaR for the quarter was CHF 162 million, down from CHF 208 million in the previous quarter, but similar to levels seen in the latter part of second quarter. Quarter-end VaR was broadly unchanged at CHF 161 million from CHF 159 million.

The standalone 99% confidence VaRs for the separate risk types such as equities and interest rates shown in the table are usually generated by different market events in the historical time series and therefore cannot simply be added. Throughout the quarter, risk factor moves and market events producing the 99% confidence interest rate VaR were typically accompanied by equities market moves which would have generated offsetting gains on our portfolio. This has resulted in the relatively large diversification effect shown in the table (which is simply the difference between the sum of the standalone VaRs across all risk types, and the VaR calculated for the Investment Bank as a whole). It also explains why total Investment Bank VaR is lower than interest rate VaR.

Market risk for UBS broadly followed Investment Bank VaR. Average VaR was CHF 464 million in third quarter, up from CHF 414 million in second quarter, while quarter-end VaR increased only slightly to CHF 398 million from CHF 396 million at the end of the previous quarter.

‘Backtesting’ compares 1-day VaR calculated on positions at the close of each business day with the actual revenues arising on those positions on the next business day (excluding intraday trading revenues, fees and commissions), and is used to monitor the quality of the VaR model. The graph below shows these two time series over the last 12 months for positions subject to market risk regulatory capital based on the VaR model. There were no backtesting exceptions.

We also routinely assess, actively manage, and control tail risks against a standard set of forward-looking stress scenarios, supplemented by specific scenarios targeting individual sectors or current concerns, such as widening credit spreads or increased energy market volatility. Stress events modeled in our standard scenarios include crises in equity, corporate bond and emerging markets, and severe movements in currency, interest rate and energy markets. These scenarios are reviewed regularly and adjusted as necessary. Stress loss exposure for the Investment Bank fluctuated over the quarter within approved limits.

VaR and stress measures control our overall portfolio exposure but we also apply concentration controls on exposure to individual market risk variables, such as individual equity markets, individual currency interest and foreign exchange rates, and single name issuers. The diversification of risks and avoidance of undue concentrations remain key pillars of our risk control process.