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 comes from the Investment Bank's trading activities. Group Treasury, part of Corporate Center, assumes foreign exchange and interest rate risk in connection with UBS's 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, representing a loss greater in absolute value than the market risk losses that would be realized over a set time period at an established probability. This assumes no change in the firm's trading positions. The tables below show this statistic calibrated to a 10-day horizon and a 99% probability. For a variety of reasons, the actual realized market risk loss experienced may differ from that implied by the VaR measures of the firm. For example, the historical period used in creating the VaR measure had fluctuations in market rates and prices that may differ from those in the future; 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 when the VaR measure was created. All VaR measures are subject to these limitations to some extent and must be interpreted accordingly. UBS continues to review the performance of its VaR implementation and will continue to enhance its VaR model to more accurately capture the relationships between the market risks associated with certain positions, as well as the revenue impact of large market movements for some trading positions.

UBS's period-end Investment Bank regulatory VaR ended the quarter at CHF 519 million, up from CHF 396 million at the prior period end. This change was driven largely by an increase in hedges used to mitigate CVA exposures from counterparties in the OTC derivatives portfolio. As noted in the sidebar, hedges are included in regulatory VaR, while the CVA exposures are not. This also resulted in a significant increase in average Investment Bank regulatory VaR to CHF 461 million compared with CHF 310 million in second quarter 2008.

Interest rate regulatory 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 regulatory VaR in third quarter 2008. Directional interest rate exposure remained stable quarter on quarter but the dominance of credit spreads in interest rate regulatory VaR increased significantly as a result of the hedging activity referred to above.

Period-end and average equities regulatory VaR remained relatively stable in third quarter compared with the prior period.

Regulatory VaR for UBS as a whole followed a similar pattern to Investment Bank regulatory VaR.

Backtesting

"Backtesting" compares one-day regulatory 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. A "backtesting exception" occurs when backtesting revenues are negative and greater than the previous day's VaR.

UBS experienced three backtesting exceptions in third quarter 2008, down from 11 the previous quarter. The exceptions occurred either on trading days with exceptional market volatility or as a result of markdowns on asset-backed security positions. Price visibility for some of these products deteriorated over the period and the changes booked on a single day can reflect the cumulative impact over several days of market intelligence.

As UBS reported in its first quarter 2008 financial report, illiquid US residential mortgage-related positions were reclassified to banking book for regulatory capital purposes and excluded from VaR and backtesting from 1 January 2008. The analysis of backtesting revenues over a one-year period is therefore split between the last three months of 2007 and the first nine months of 2008, as illustrated in the histograms (see the graphs above). Histograms comparing daily backtesting revenues with the corresponding VaR for days when the backtesting revenues are negative are also shown on this basis. In these histograms, a positive result represents a loss less than VaR and a negative result represents a loss greater than VaR, and therefore a backtesting exception. The histogram above shows all daily revenues from businesses with trading activities, including positions classified as banking book for regulatory capital purposes, and covers the 12 months to 30 September 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.