Market risk

There are two broad categories of market variables – general market risk factors and idiosyncratic components. 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 changes in the level, slope or shape of yield curves (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 risks factors – 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.

We take market risk primarily in our trading activities, but some of our non-trading businesses also create market risks.

Trading

Most of our trading activity is in the Investment Bank. It includes market-making, facilitation of client business and proprietary position taking in the cash and derivative markets for fixed income, equities, interest rate products, foreign exchange, energy, metals and commodities.

In our fixed income business we carry inventory in support of market-making and client facilitation. Although inventory levels vary and the portfolio is well diversified, the credit spread exposure (a component of interest rate risk) from these positions is generally the largest contributor to VaR.

Exposure to movements in the level and shape of yield curves arises in all our trading activities but predominantly in the Rates, FX and Cash and Collateral Trading businesses. Our exposure to directional interest rate movements varies depending on our view of the markets. It is often these variations that drive changes in the level of Investment Bank VaR, although the impact of any switch depends on the composition of the whole portfolio at the time.

Equity risk is the other major contributor to Investment Bank market risk. We generally have exposure to all major equity markets and an increasing number of newer markets, partly from index-based transactions but also from individual stocks, giving rise to idiosyncratic as well as general market risk. A significant component of equity VaR is event risk from proprietary positions, which we take, for example, to capture arbitrage opportunities or price movements resulting from mergers and acquisitions.

We are active in the currency, energy, metals and commodities markets, but while trading volumes are substantial, their contribution to overall market risk is generally relatively small.

Outside the Investment Bank, in Global Asset Management, investments in support of our alternative and quantitative investments platform in the start up phase of new funds contribute modestly to our reported market risk. Our Wealth Management operations carry only small positions, to support client activity.

Non-trading

Within the Investment Bank, material non-trading interest rate and all foreign exchange risks are captured, controlled and reported in the same risk management and control framework as trading risk.

In the other Business Groups, exposures to general market risk factors – primarily interest rates and exchange rates – also arise from non-trading activities, the largest items being the interest rate risks in Global Wealth Management & Business Banking. These, and most other material risks, are transferred to Treasury (part of the Corporate Center) or the Investment Bank, where they are managed as part of the overall portfolios of these units. Risks that are retained by the other Business Groups are not significant relative to UBS's overall risk, but all market risks are subject to controls, and all foreign exchange positions are captured in VaR.

Treasury assumes market risk as a result of its balance sheet and capital management activities. It manages interest rate risk transferred from other Business Groups and from the funding of items such as property and investments. Treasury is also responsible for managing UBS's consolidated equity in order to protect our capital ratios and generate a stable interest income stream.

Investment positions

We hold equity investments for a variety of business purposes other than trading. Private equity investments were, in the past, the major component but exposure has been ­reduced in line with our strategy to de-emphasize this asset class. We have a significant investment in Bank of China, acquired as part of a major strategy initiative. We also took a non-strategic stake in Julius Baer when they acquired Private Banks & GAM from UBS at the end of 2005. Most seed money and co-investments in UBS funds are ­classified as investment positions and we have equity holdings, such as exchange and clearing house memberships and stakes in trading platforms, to support other business activities.

Many of these investments are unlisted and therefore illiquid. Others are intended to be – or required to be – held medium- to long-term and not all the associated risks can be hedged or closed out. The fair values of equity investments are often driven more by idiosyncratic factors than by movements in equity markets. For these reasons, equity investments are controlled outside the market risk framework. They are, however, subject to independent risk controls and both business management and risk control pre-approval is required for new investments. Where they are made as part of an ongoing business they are also subject to portfolio and concentration limits.