Risk Management and Control

Market risk arises primarily in UBS's trading activities, which are mainly in the Investment Bank, with limited activity in wealth management to facilitate private client business, and in asset management to support our alternative and quantitative investments area. Additionally, our Treasury department (part of Corporate Center) assumes foreign exchange and interest rate risk as a result of its balance sheet and capital management responsibilities.

Credit, interest rate and equities market sentiment in first quarter was dominated by concerns about the US economy, inflation and housing market. The US sub-prime mortgage market suffered a major dislocation in February resulting in significant markdowns and reduced liquidity, with limited contagion to other markets. The upward trend of equity markets came to a halt at the end of February with sharp falls in market indices and an upward spike in associated volatilities. For the quarter as a whole, most indices were marginally up from year-end levels.

Investment Bank Value at Risk (VaR) continued the upward trend seen at the end of 2006 and was generally more volatile than in previous quarters. Average VaR (10-day, 99% confidence, 5 years of historical data) increased to CHF 517 million from CHF 391 million in fourth quarter 2006, while the range (the difference between maximum and minimum VaR) increased to CHF 258 million from CHF 162 million.

As reported for fourth quarter 2006, the integration of Pactual from 1 December 2006 has resulted in an increase in average VaR for the Investment Bank. In first quarter, the inclusion of Pactual for the full period had a more pronounced impact, and contributed to the higher and more volatile interest rate VaR.

Towards the end of 2006, we increased our exposure to general equity market movements and this stance was maintained for much of first quarter 2007. This not only increased equity VaR but also reduced the offsetting effect that equity positions have, in the past, typically provided against interest rate exposure.

Other significant contributors to the level and variability of VaR were increased credit spread exposure towards the end of the quarter, and a number of equity proprietary trading opportunities.

Average VaR for UBS as a whole was CHF 516 million in first quarter, up from CHF 395 million in fourth quarter 2006. As in the previous quarter, Investment Bank VaR exceeded UBS VaR on occasions – including quarter-end – as Corporate Center exposures provided some offset to Investment Bank positions.

Global Asset Management seed money and co-investments in alternative and quantitative funds are now ­accounted for as financial investments, consistent with equivalent investments in other UBS funds, and are no ­longer included in VaR reported for Global Asset Management.

"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). It is used to monitor the quality of the VaR model. The graph below shows these daily backtesting revenues and the corresponding 1-day VaR over the last 12 months, for positions subject to market risk regulatory capital based on the VaR model. As in previous quarters, we had no backtesting exceptions in first quarter.

As an essential complement to VaR, we run macro stress scenarios bringing together various combinations of potential market moves to reflect the most common types of possible stress event. These include a developed country market crash with a range of yield curve and credit spread behavior, and emerging market crises with and without currency pegs breaking. We also run a general recovery scenario. The standard scenarios are run daily and it is against these that we set limits on our stress loss exposure, track its development and make comparisons from one period to the next. The macro scenarios are supplemented as necessary by specific scenarios targeting individual sectors or reflecting current concerns.

Investment Bank stress exposure, like VaR, followed the trend seen at the end of the previous quarter and was on average higher and more volatile in first quarter. Late in the quarter, exposures to more extreme tail events were reduced to below the year-end 2006 level.

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 exchange rates, and single names. The diversification of risks and avoidance of undue concentrations are key components of our risk control process.