Note 29 Financial Instruments Risk Position

This Note presents information about UBS's management and control of risks from financial instruments.

Part a) presents an overview of UBS's risk management and control objectives.

Parts b) to d) provide more detailed explanations of the primary risks associated with UBS's use of financial instruments:

– market risk – part b) – is exposure to market variables including general market risk factors such as interest rates, exchange rates, equity market indices and commodity prices, and factors specific to individual names affecting the values of securities and other obligations in tradable form, and derivatives referenced to these names

– credit risk – part c) – is the risk of loss as a result of failure by a client or counterparty to meet its contractual obligations

– liquidity risk – part d) – is the risk that UBS is unable to meet its payment obligations when due.

Part e) presents and explains the Group's regulatory capital position.

This Note generally refers only to UBS's Financial Businesses, and those tables which are based on risk information include only the Financial Businesses of the Group. Those which present an analysis of the whole balance sheet also cover the positions of the Industrial Holdings segment which, for the 2005 tables, includes Motor-Columbus.

Any representation of risk at a specific date offers only a snapshot of the risks taken, since both trading and non-­trading positions can vary significantly on a daily basis, for a variety of reasons, including active risk management. As such, it may not be representative of the level of risk at other times.

a) Risk Management & Control Objectives

Taking risk is core to a financial services business. UBS's risk management and control objective is not, therefore, to eliminate all risks but to achieve an appropriate balance between risk and return. In day-to-day business and in the strategic management of the balance sheet and capital position, UBS seeks, through its risk management and control framework, to limit the scope for adverse variations in earnings and exposure to "stress" events.

The underlying objective is the creation and protection of shareholder value and the framework is built around the following principles:

– business management is accountable for all risks assumed and is responsible for their continuous and active management

– an independent control process is implemented to provide an objective check on risk-taking activities when required by the nature of the risks, in particular to balance short term profit incentives and the long term interests of UBS. All exposures are independently monitored and reviewed and, depending on the nature of the risks, may also require pre-approval

– comprehensive, transparent and objective risk disclosure to senior management, the Board of Directors, share­holders, regulators, rating agencies and other stake­holders is the cornerstone of the risk control process

– risks are controlled at the level of individual exposures, at a portfolio level, and in aggregate across all businesses and risk types to protect the Group's earnings

– managing and controlling risks, and in particular avoiding undue concentrations of exposure, limiting potential ­losses from stress events, and restricting significant positions in less quantifiable risk areas, are essential elements of the risk management and control framework and the protection of UBS's reputation.

Excellence in risk management is fundamentally based upon a management team that makes risk identification and control critical components of its processes and plans.

The Group Chief Risk Officer (CRO) has overall responsibility for the development and implementation of the Group's risk control principles, frameworks, limits and processes, including formulation of risk policies and risk measurement and assessment methodologies.

b) Market Risk

(i) Overview

Market risk is exposure to market variables including general market risk factors such as interest rates, exchange rates, equity indices, and commodity prices, and factors specific to individual names affecting the values of securities and other obligations in tradable form, and derivatives referenced to those names ("issuer risk").

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 in support of the alternative and quantitative investments area. Additionally the Treasury ­department (part of Corporate Center) assumes market risk through its balance sheet and capital management activities.

The trading activities of the Investment Bank include market making, facilitation of client business and proprietary ­position taking. UBS is active in cash and derivatives markets for equities, fixed income and interest rate products, and for foreign exchange, energy, metals and commodities. Treasury assumes non-trading market risks. Interest rate risk arises from the funding of non-business items such as property and investments and from long-term interest rate risk transferred from other Business Groups. Foreign exchange risk arises from the management of foreign currency profits and losses. Treasury also manages the Group's consolidated ­equity in such a way as to protect UBS's capital ratios and to generate a stable interest income flow. Other market risks from non-trading activities, predominantly interest rate risk, arise in all Business Groups, but they are not significant.

The Group Head of Market Risk, reporting to the Group CRO, has overall responsibility for formulating the Group's market risk control framework. There is a CRO in each Business Group and a designated CRO for Treasury. The Group Head of Market Risk, the Business Group CROs and their teams are responsible for the independent control of market risk. They ensure that all market risks are identified and captured in risk systems. They establish the necessary controls, including limits, and monitor positions and exposures. An important element of the CRO's role is the assessment of market risk in new businesses and products, and in structured transactions.

Market risk authority is vested in the Chairman's Office and is further delegated to the GEB and ad personam to the Group CRO, the Group Head of Market Risk and CROs and market risk officers in the Business Groups.

Market risk measures and controls are applied at the portfolio level, and concentration limits and other controls are applied where necessary to individual risk types, to particular books and to specific exposures. Portfolio risk measures are common to all market risks, but concentration limits and other controls are tailored to the nature of the activities and the risks they create.

The principal portfolio risk measures and limits on market risk are Value at Risk (VaR) and stress loss.

VaR is a statistically based estimate of the potential loss on the current portfolio from adverse market movements. The VaR measure captures both "general" and "idiosyncratic" market risks. General market risk factors are variables which are driven by macroeconomic, geopolitical and other market-wide considerations, independent of any instrument or single name. They include movements in interest rates, widening or tightening of general spread levels and directional movements in equity market indices, exchange rates, and energy, metal and commodity prices. Changes in associated volatilities, and correlations between these risk factors – some of which may be unobservable or only indirectly observable – are also general market risks. Idiosyncratic components are those that cannot be explained by general market moves – broadly, changes in the prices of debt and equity instruments and derivatives linked to them, resulting from factors and events specific to individual names.

VaR expresses potential loss, but only to a certain level of confidence (99%), and there is therefore a specified statistical probability (1%) that actual loss could be greater than the VaR estimate. UBS's VaR model measures risk over a 10-day time horizon and it assumes that market moves occurring over this horizon will follow a similar pattern to those that have ­occurred over 10-day periods in the past. For general market risk, the assessment of past movements is based on data for the past five years, and these are applied directly to current positions, a method known as historical simulation. For idiosyncratic risk, including event risk, the methods and time horizons are adjusted to most appropriately capture the risks.

Stress loss measures are run daily. They quantify exposure to more extreme market movements than are normally ­reflected in VaR, under a variety of scenarios, and are an ­essential complement to VaR.

Controls and restrictions are placed on risk concentrations in trading books, taking into account variations in price volatility and market liquidity. They include measures of ­exposure to individual market risk variables, such as the ­exchange rates and interest rates of particular currencies ("market risk factors"), and on positions in the securities and other tradable obligations of individual names or groups, or derivatives referenced to such names ("issuer risk" – see ­section b)(v)).

(ii) Interest rate risk

Interest rate risk is the risk of loss resulting from changes in interest rates, including changes in the shape of yield curves. It is controlled primarily through the limit structure described in section b)(i). Interest rate sensitivity is one of the key inputs to VaR. One way of expressing this sensitivity for all interest rate sensitive positions, whether marked to market or subject to amortized cost accounting, is the impact on their fair values of a one basis point (0.01%) change in interest rates. This sensitivity, analyzed by time band, is set out in the table below.

The table sets out the extent to which UBS was exposed to interest rate risk at 31 December 2006 and 2005. It shows the net impact of a one basis point (0.01%) increase in market interest rates across all time bands on the fair values of interest rate sensitive positions, both on- and off-balance sheet. The impact of such an increase in interest rates depends on UBS's net asset or net liability position in each ­category, currency and time band in the table. A negative amount in the table reflects a potential reduction in fair ­value, while a positive amount reflects a potential increase in fair value.

Positions shown as "trading" are those which contribute to market risk regulatory capital, i. e. those considered "trading book" for regulatory capital purposes – see part e). "Non-trading" includes all other interest rate sensitive assets and liabilities including derivatives designated as hedges for accounting purposes (as explained in Note 23) and off-balance sheet commitments on which an interest rate has been fixed. The regulatory capital definition of the trading book is broadly consistent with, but not identical to, the accounting definition of the trading portfolio. Most notably, loans originated by UBS for distribution in the cash markets are classified as held for trading for accounting purposes, but are risk controlled under the credit risk framework – see part c) – and are not eligible for trading book regulatory capital treatment.

Information about money market paper and debt instruments ­classified as trading portfolio for accounting purposes is included in Note 12 and of debt instruments defined as ­financial investments available-for-sale for accounting purposes in Note 13. Information about derivatives is shown in Note 23. It should be noted that interest rate risk arises not only on interest rate contracts but also on other forwards, swaps and options, in particular on forward foreign exchange contracts. Off-balance sheet commitments on which an interest rate has been fixed are primarily forward starting fixed-term loans.

Trading

The major part of this risk arises in the Investment Bank in particular in the Fixed Income, Rates and Currencies business area, which includes the Cash and Collateral Trading unit (CCT).

Non-trading

Interest rate risk is inherent in many of UBS's businesses and arises from factors such as differences in timing between contractual maturity or re-pricing of assets, liabilities and derivative instruments. Most material non-trading interest rate risks are transferred from the originating business units to one of the two core interest rate risk management units – Treasury and CCT. The risks are then managed within the market risk limits and controls described in section b)(i).

The largest non-trading interest rate exposures arise in the Global Wealth Management & Business Banking Business Group. Many of their retail banking products have no contractual maturity date or directly market-linked rate. Their interest rate risk is transferred on a pooled basis through "replicating" portfolios. A replicating portfolio is a series of loans or deposits at market rates and fixed terms between the originating business unit and Treasury, structured to approximate – on average – the interest rate cash flow and re-pricing behaviour of the pooled client transactions. The portfolios are rebalanced monthly. Their structure and parameters are based on long-term market observations and client behavior, and are reviewed periodically. Product margin remains with, and is subject to additional analysis and control by the originating business units.

Interest rate risk also arises from non-business related ­balance sheet items such as the financing of bank property and equity investments in associated companies. The risk on these items is transferred to Treasury through replicating portfolios which, in this case, are designed to approximate the mandated funding profile.

The Group's consolidated equity is managed in accordance with strategic targets set by senior management and is placed at fixed interest rates in Swiss franc, US dollar, euro and UK sterling with an average duration of between three and four years. These positions account for CHF 17.1 million of the non-trading interest rate sensitivity shown in the table on the previous page, with CHF 7.4 million arising in Swiss franc, CHF 8.4 million in US dollar and the remainder in euro and UK sterling. The interest rate sensitivity of the positions is directly related to the chosen duration, and although adopting significantly shorter maturities would lead to a reduction in apparent interest rate sensitivity, it would lead to higher volatility in interest earnings.

The economic value sensitivity of non-trading interest rate positions is defined as the impact of a large (100 basis point) instantaneous rise in interest rates across all currencies, on the net present value of all future cashflows from these positions. At 31 December 2006 the economic value sensitivity was a loss of CHF 1,771 million.

(iii) Currency risk

Currency risk is the risk of loss resulting from changes in ­exchange rates.

Trading

UBS is an active participant in currency markets and carries currency risk from these trading activities, conducted primarily in the Investment Bank. These trading exposures are subject to the VaR, stress and concentration limits described in section b)(i). Information about foreign exchange contracts, most of which arise from trading activities and contribute to currency risk, is provided in Note 23.

Non-trading

UBS's reporting currency is the Swiss franc, but its assets, liabilities, income and expense are denominated in many currencies, with significant amounts in US dollar, euro and UK sterling, as well as Swiss franc.

Reported profits or losses are exchanged monthly, and in some cases more frequently, into Swiss francs, reducing volatility in the Group's earnings from subsequent changes in exchange rates. Treasury also, from time to time, proactively hedges significant expected foreign currency earnings/costs (mainly US dollar, euro and UK sterling) in accordance with the instructions of the Group Executive Board. Economic hedging strategies employed include a cost-efficient options purchase program, which provides protection against unfavorable currency fluctuations while preserving some upside potential. Although these positions are intended to economically hedge future earnings, they can cause volatility in financial results because they are marked to market. Within clearly defined tolerances, such fluctuations are accepted. The positions are, however, treated as currency exposure, are subject to Treasury's VaR limit and are included in VaR for regulatory capital purposes. The hedge program has a time horizon of up to twelve months and is not restricted to the current financial year.

The Group's consolidated equity is managed – as described in section b)(ii) – in such a way as to protect UBS's capital ratios from exchange rate movements, based on a target profile that broadly reflects the currency distribution of its risk-weighted assets. This creates structural foreign currency exposures. Exchange rate movements lead to increases or decreases in the Swiss franc value of the Group's risk-weighted assets. They also generate translation gains or losses on the structural foreign currency exposures. These are recorded in Equity in the Group's Financial Statements, thereby protecting the BIS Tier 1 capital ratio – see part e).

At 31 December 2006, the largest combined trading and non-trading currency exposures against the Swiss franc were short USD 436 million, short EUR 195 million and long AUD 128 million. At 31 December 2005, the largest exposures were short USD 695 million, short EUR 36 million and long GBP 6 million.

(iv) Equity risk

Equity risk is the risk of loss resulting from changes in the levels of equity indices and values of individual stocks.

The Investment Bank is a significant player in major equity markets and is increasingly active in the newer markets. It carries equity risk from these activities. These exposures are subject to the VaR, stress and concentration limits described in section b)(i) and, in the case of individual stocks, to the ­issuer risk controls described in section b)(v).

Information about equities held for trading for accounting purposes is given in Note 12. Information about equity derivatives contracts (on indices and individual equities), which arise primarily from the Investment Bank's trading activities, is provided in Note 23.

(v) Issuer risk

Issuer risk is the risk of loss on securities and other obligations in tradable form (including traded loans), and on derivatives based on such assets. It arises from credit-related and other events and, ultimately, default of the issuer, obligor or reference name.

As an active trader and market maker, the Investment Bank holds positions in these instruments, which are included in VaR and are also subject to controls on concentrated exposure to individual names and groups.

Exposures arising from security underwriting commitments are, additionally, subject to targeted processes prior to commitment, generally including review by a commitment committee with representation from both business management and the control functions. All commitments are approved under specific delegated authorities.

(vi) Investment positions

UBS makes equity investments for a variety of purposes. Some are made for revenue generation or as part of strategic initiatives, while others, such as exchange and clearinghouse memberships, are held in support of other business activities. Private equity positions were, in the past, the major component of equity investments but the portfolio is being managed down. UBS made an investment in Bank of China as part of a major strategy initiative, and acquired a stake in Julius Baer when Private Banks & GAM was sold to them in December 2005. Most seed money and co-investments in UBS funds are considered investment positions.

Many equity investments are unlisted and therefore ­illiquid. Others are intended to be held medium- or long-term. The fair values are often driven more by factors specific to the individual companies than movements in general equity markets. For these reasons, equity investments are controlled outside the market risk measures and controls described in sections b)(iv) and b)(v). Instead they are subject to control and reporting processes, including pre-approval of new investments by business management and risk control. Where investments are made as part of an ongoing business they are also subject to portfolio and concentration limits.

Debt investments, including money market paper, are not significant in amount. They are included in the measures of interest rate risk described in section b)(ii).

c) Credit Risk

Credit risk is the risk of loss to UBS as a result of failure by a client or counterparty to meet its contractual obligations. It is inherent in traditional banking products – loans, commitments to lend and contingent liabilities, such as letters of credit – and in traded products – derivative contracts such as forwards, swaps and options, repurchase agreements (repos and reverse repos) and securities borrowing and lending transactions. Some of these products are accounted for on an amortized cost basis, while others are recorded in the Financial Statements at fair value. Banking products are generally carried at amortized cost, but loans are carried at fair value if they have been originated by the Group for subsequent syndication or distribution through the cash markets or (with effect from June 2006) are to be substantially hedged. OTC derivatives are carried at fair value. Repos and securities borrowing and lending transactions are accounted for on an amortized cost basis. All banking and traded products are governed by the same credit risk management and control framework, regardless of accounting treatment.

The Group Chief Credit Officer (CCO), reporting to the Group CRO, has overall responsibility for formulating the Group's credit risk control framework. Global Wealth Management & Business Banking and the Investment Bank, which take material credit risk, have independent credit risk control units, headed by CCOs reporting functionally to the Group CCO. They are responsible for the rating of counterparties, for credit risk assessment and for the continuous monitoring of counterparty and portfolio credit exposures. Credit risk authority, including authority to establish allowances, provisions and credit valuation adjustments for impaired claims, is vested in the Chairman's Office and is further delegated to the GEB and ad personam to the Group CCO and to the Business Group CCOs and credit officers.

For credit risk control purposes, credit exposure is measured for banking products as the nominal amount. For traded products, credit exposure is based on the replacement value of contracts, taking account of master netting agreements with individual counterparties where they are considered enforceable in insolvency. The potential replacement value is projected over the life of the contracts (or over a shorter time frame where UBS has the ability to reduce exposure or close out, for example by calling or liquidating collateral) reflecting changes in credit exposure resulting from market movements and from maturing contracts. UBS actively uses credit risk mitigation techniques to manage credit exposure. These include risk transfers and participations, hedging with credit derivatives, taking of security in the form of financial collateral (cash or marketable securities) or other assets such as real estate, and guarantees and other third party support. For internal credit risk control, credit risk mitigation is reflected – depending on the product and type of mitigation – by recognizing its existence in determining the exposure UBS is prepared to carry or by reflecting its risk- reducing effect in the reported credit exposure.

In the table, the amounts shown as credit exposure for banking products are based on accounting classification and include some items which are not considered to be credit exposures for internal purposes, notably cash collateral posted by UBS with market counterparties against negative replacement values on derivatives. Credit risk mitigation is ­recognized only to the extent that assets are derecognized for accounting purposes, as explained in Note 1a4). The amounts shown in the table for traded products are based on regulatory capital treatment, as shown in the table in part e). It should be noted that, for regulatory capital purposes, netting of positive and negative replacement values on derivatives is permitted for counterparties with whom UBS has a master netting agreement that is enforceable in insolvency, but netting is not permitted for accounting purposes unless the cash flows will actually be settled net, which is not generally the case – for details see Note 23. The regulatory capital treatment of securities borrowing and lending transactions and repo and reverse repo transactions is based on the net positive value of cash or securities given by UBS to the counterparty. These values are included in the table in part e) in Due from banks and other collateralized lendings. They are only a small percentage of the balance sheet amounts which are based on the full value of transactions – for details see Note 11. The amounts shown in the table for traded products do not include any estimate of the potential future exposure which is included in the internal credit risk control view.

UBS manages, limits and controls concentrations of credit risk wherever they are identified, in particular to individual counterparties and groups, and to industries and countries where appropriate. Concentrations of credit risk exist if clients are engaged in similar activities, or are located in the same geographic region or have comparable economic characteristics such that their ability to meet contractual obligations would be similarly affected by changes in economic, political or other conditions. UBS sets limits on its credit exposure to both individual counterparties and counterparty groups.

UBS's credit portfolio is heterogeneous, varying significantly in terms of client type, sector, geographical diversity and the size of exposures. Limits take a variety of forms such as nominal values, statistical measures and scenario-based stress loss. They are applied to individual portfolios or sectors where appropriate, to restrict credit risk concentrations or areas of higher risk, or to control the rate of portfolio growth. Stress loss limits are applied to exposures to all but the best-rated countries.

Aggregate risk across portfolios is measured using a proprietary statistical methodology which provides an indication of risk in the portfolio and the way it changes over time. Stress loss measures are applied to all significant portfolios to assess the impact of variations in ­default rates and asset values, taking into account risk concentrations in each portfolio. These measures include an ana­lysis of contribution by industry and geography.

The Group's gross lending portfolio of CHF 364 billion is widely diversified across industry sectors with no significant concentrations of credit risk. CHF 153 billion (42% of the total) consists of loans to thousands of private households, predominantly in Switzerland, and mostly secured by mort­gages, financial collateral or other assets. Exposure to banks and financial institutions amounted to CHF 138 billion (38% of the total).