Risk categories

Market risk is the risk of loss resulting from changes in market variables of two broad types: general market risk factors and idiosyncratic components. General market risk factors include interest rates, exchange rates, equity market indices, commodity prices and general credit spreads. Idiosyncratic components are specific to individual names and affect the values of their securities and other obligations in tradable form, and derivatives referenced to those names.

Most of UBS's market risk arises from the Investment Bank's trading activities. Group Treasury, part of Corporate Center, assumes foreign exchange and interest rate risk in connection with its balance sheet, profit and loss, and capital management responsibilities, while the wealth and asset management operations take limited market risk in support of client business.

Value at Risk

Value at Risk (VaR) is a statistical measure of market risk that represents a loss amount that should be greater in absolute value than the realized market risk losses the firm will experience over a set time horizon, assuming no change in the Firm's trading positions, at an established probability. The tables below show this statistic calibrated to a 10-day horizon and a 99% probability. The actual realized market risk loss experience may differ from that implied by the VaR measures of the firm for a variety of reasons. For example, fluctuations in market rates and prices in the future may differ from those evidenced during the historical period used in creating the VaR measure; the firm's intra-period trading may mute or accentuate the losses; and the revenue consequences of a market move may differ from what is assumed in creating the VaR measure. All VaR measures are subject to these limitations to some extent and must be interpreted accordingly. Reviews of the performance of the VaR implementation at the firm indicate that the VaR measures did not accurately capture the relationships between the market risks associated with certain positions, particularly credit exposures, as well as the revenue impact of large market movements for some trading positions.

UBS continues to enhance its market risk measures and processes to improve the performance of the VaR model, particularly in light of the number of times daily negative revenues have exceeded reported VaR in recent quarters. Towards the end of second quarter 2008, UBS increased the granularity of credit spread risk representation in its VaR model between derivative, index and cash positions. This had a significant impact on period-end Investment Bank VaR (10-day-99% confidence based on five years of historical data) which ended the quarter at CHF 388 million, up from CHF 299 million at the prior period end. Average Investment Bank VaR, however, was less impacted and rose only slightly to CHF 313 million compared with CHF 306 million in first quarter 2008.

Interest rate VaR, which includes exposure to movements in general credit spreads as well as exposure to the level and shape of yield curves, continued to be the key driver of Investment Bank VaR in second quarter 2008. Directional interest rate exposure remained stable quarter-on-quarter. Credit spreads remained the dominant component of interest rate VaR, which increased significantly at the end of the quarter as a result of the more granular representation of credit spread risks referred to above. Without this enhancement, interest rate VaR would have been largely unchanged over the quarter.

Period-end and average equities VaR decreased over second quarter as a result of active reduction of single stock positions.

Average and maximum VaR for Corporate Center, which is generated entirely by Group Treasury positions, was high by recent standards. This resulted from temporary positions associated with Group Treasury's management of the foreign exchange component of parent bank profit and losses. As in previous periods, VaR for UBS as a whole followed a similar pattern to Investment Bank VaR.

Backtesting

"Backtesting" compares 1-day VaR calculated on positions at the close of each business day with the revenues arising on those positions on the following business day. These "backtesting revenues" exclude non-trading revenues, such as fees and commissions, and estimated revenues from intraday trading. When backtesting revenues are negative and greater than the previous day's VaR, a "backtesting exception" occurs.

As reported in first quarter 2008, illiquid US residential mortgage-related positions were reclassified to banking book for regulatory capital and excluded from VaR and backtesting from 1 January 2008. In second quarter 2008, positions in student loan auction rate securities were also reclassified to banking book for regulatory capital and excluded from backtesting due to illiquidity of the positions but remain in VaR for risk control.

UBS experienced a further 11 backtesting exceptions in the first half of second quarter, largely as a result of the unprecedented credit spread tightening in this period and differential movements between asset classes that had previously been well correlated, which highlighted basis risks. Enhancements to the VaR model, which were made in second quarter, should address some of these issues and further improvements are planned.

The analysis of backtesting revenues over a one-year period is split between first half 2008 and the prior six months, as illustrated in the histograms above. Histograms comparing daily backtesting revenues with the corresponding VaR for days when the backtesting revenues are negative, are also shown on this basis. A positive result represents a loss less than VaR and a negative result represents a loss greater than VaR, and was therefore a backtesting exception. The histogram shows all daily revenues from businesses with trading activities, including positions classified as banking book for regulatory capital, and covers the 12 months to 30 June 2008.

As an essential complement to VaR, UBS runs macro stress scenarios bringing together various combinations of market moves to reflect the most common types of potential stress events, and more targeted stress tests for concentrated exposures and vulnerable portfolios.