Market risk

Market risk is the risk of loss from changes in market variables. There are two broad categories of changes: general market risk factors and idiosyncratic components. General market risk factors are driven by macroeconomic, geopolitical and other market-wide considerations, independent of any instrument or single issuer or counterparty. They include such things as interest rates, the levels of equity market indices, exchange rates, commodities (including the price of energy and metals), as well as general credit spreads. The associated volatility of these risk factors and the correlations between them are also considered to be general market risk factors. Idiosyncratic components, on the other hand, are those that cannot be explained by general market moves. Broadly they are the elements of the prices of debt and equity instruments, as well as derivatives linked to them, which result from factors and events specific to individual companies or entities.

Sources of market risk

UBS takes both general and idiosyncratic market risks in its trading activities, and some non-trading businesses are also subject to general market risks.

Trading

Most of UBS's trading activity is in the Investment Bank. During 2008 it included market-making, facilitation of client business and proprietary position taking in the cash and derivative markets for equities, fixed income, interest rates, foreign exchange, energy, metals and commodities. However, the Investment Bank is being repositioned to focus primarily on client activities. In addition to the planned exit from municipals, proprietary trading and commodities (excluding precious metals) businesses, the Investment Bank will also largely exit its remaining real estate and securitization activities as well as the exotic structured products business. Refer to the "Investment Bank" section of this report for further information.

The largest contributor to market risk within the Investment Bank has been the fixed income trading area. This business area has been progressively reducing risk positions. Those that remain relate to coporate and consumer credit markets, US municipal and student loan markets, as well as significantly reduced positions in asset-backed securities (including residential and commercial real estate).

The relative contribution from a market risk perspective from equities, currencies and commodities has been modest compared to that seen in the fixed income trading area.

Trading businesses are subject to multiple market risk limits. Traders are required to manage their risks within these limits which in turn may involve employing hedging and risk mitigation strategies. These strategies can expose UBS to risk as the hedge instrument and the position being hedged may not always move in parallel (often referred to as "basis risk"). Senior management and risk controllers may also give instructions for risk to be reduced, even when limits are not exceeded, if particular positions or the general levels of exposure are considered inappropriate.

The asset management and wealth management businesses carry small trading positions, principally to support client activity. The market risk from these positions is not material to UBS as a whole. UBS has also bought and may be required to buy securities and units from funds that UBS has sold to clients, which may be exposed to market risk. These positions are managed as investment positions. Refer to the "Equity investments" section below for further information.

Non-trading

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

In the other business divisions, exposures to general market risk factors - primarily interest rates and exchange rates - also arise from non-trading activities (the largest items are the interest rate risks in Global Wealth Management & Business Banking). These market risks are generally transferred to the Investment Bank or Group Treasury, which manage the positions as part of their overall portfolios within their allocated limits.

Market risks that are retained by the other business divisions are not significant relative to UBS's overall risk, and exposures are subject to market risk measures and controls. With the exception of structural currency exposures which arise from Group Treasury's management of consolidated capital, non-trading currency and commodity positions are subject to market risk regulatory capital and are therefore captured in VaR, although such positions do not contribute significantly to overall VaR.

Group Treasury also assumes market risk from its funding, balance sheet and capital management responsibilities. For example, it finances non-monetary balance sheet items such as bank property and equity investments in associated companies. It also manages interest rate and foreign exchange risks resulting from the deployment of UBS's consolidated equity, from structural foreign exchange positions and from non-Swiss franc revenues and costs. The market risk limits allocated to Group Treasury cover both the risks resulting from these responsibilities, and those transferred from other business divisions.

Refer to the "Treasury management" section of this report for more information on Group Treasury's risk management activities.

Measuring market risk

UBS has two major portfolio measures of market risk - VaR and stress loss - which are common to all business divisions. They are complemented by concentration and other supplementary limits on portfolios, sub-portfolios, asset classes or products for specific purposes where standard limits are not considered to provide comprehensive control. They may also be applied to complex products for which not all model input parameters are observable, and which thus create challenges for valuation and risk measurement. Operational limits can take a variety of forms including values (market, nominal or notional) or risk sensitivities (a measure of exposure to a given risk factor such as interest rates or credit spreads). These "operational limits" are intended to address concerns about the extent of market liquidity, available operational capacity or valuation uncertainty, for example.

Market risk limits are set for each of the business divisions and Group Treasury. The limit framework in the Investment Bank is clearly more detailed than the other divisions reflecting the nature of the risks it takes and the capacity in which it takes risks.

Value at Risk (VaR)

VaR is a statistical estimate of potential loss from adverse movements in market risk factors. A single VaR model is used for both internal limit purposes and for determining market risk regulatory capital requirements. However, the population of risk positions included in the internal management VaR measure differs from the regulatory VaR -measure, largely due to required exclusions from regulatory VaR. UBS's internal management VaR includes interest rate risk from banking book positions and credit spread sensitivities related to counterparty exposures in the OTC derivatives portfolios (referred to as credit valuation adjustment - CVA). The inclusion of CVA in internal management VaR resulted in a material difference between this measure and the regulatory VaR. In third quarter 2008, UBS changed its VaR disclosure and now presents both the regulatory and internal VaR.

UBS measures VaR using a 10-day time horizon for regulatory and for internal purposes, while VaR backtesting is based on a 1-day time horizon (refer to the discussion on backtesting below for more information). VaR is calculated daily, based on end-of-day positions, and is not subsequently restated to reflect any retrospective adjustments to position valuations. VaR models are based on historical data and thus implicitly assume that market moves over the next 10 days or one day will follow a similar pattern to those that have occurred over 10-day and one-day periods in the past. UBS uses a look-back period of five years which generally captures the cyclical nature of financial markets but may be slow to react to periods of heightened volatility. UBS applies these historical changes directly to current positions, a method known as historical simulation.

Realized market losses can differ from those implied by the VaR measure for many reasons. All VaR measures are subject to limitations and must be interpreted accordingly. The losses experienced by UBS in 2008 highlight the limitations of VaR as an absolute measure of risk and reinforce the need for multiple views of risk exposure. As an essential complement to VaR, UBS applies stress scenarios reflecting different combinations of market moves intended to capture a range of potential stress events, and more targeted stress tests for concentrated exposures and vulnerable portfolios.

VaR developments in 2008

UBS made a number of changes to its VaR model in 2008, while also changing the scope of the regulatory and internal management VaR to better reflect the underlying risks. These changes significantly inpacted the levels of VaR in 2008 compared with 2007, and are summarized below.

- From 1 January 2008, UBS changed its approach to internal risk control for illiquid US residential mortgage-related exposures: US sub-prime and Alt-A residential mortgage-backed securities (RMBS); super senior RMBS collateralized debt obligations (CDOs); the US reference-linked note program; and related hedges. These positions were excluded from internal management VaR and related limits with new controls were instituted directly over the volume of remaining positions in these categories. As the regulatory capital treatment changed from trading book to banking book, these positions were also excluded from regulatory capital VaR.

- In second quarter 2008, positions in student loan auction rate securities (ARS) were reclassified from trading book to banking book for regulatory capital purposes and excluded from regulatory capital VaR and backtesting due to the illiquidity of the positions.

- Enhancements to the VaR model were introduced at the end of June 2008 to increase the granularity of credit spread risk representation between single name CDS, several CDS indices and cash positions.

- UBS increased the scope of its internal management VaR in third quarter 2008 to more accurately represent risk exposures and related hedges. Before these changes, certain credit hedges were included in VaR but the underlying credit exposures were not, resulting in an inconsistent treatment for risk monitoring and control. UBS therefore incorporated into its internal management VaR the impact of changes in credit spread sensitivities relating to counterparty exposures in its OTC derivatives portfolio. However, when computing regulatory capital these credit spread sensitivities are currently excluded. Refer to the "Value at Risk developments - treatment of CVA" sidebar in UBS's third quarter 2008 financial report for more information.

- In fourth quarter 2008, UBS introduced additional granularity between certain cost of funding measures - Libor and the overnight index swap (OIS) rate. In addition, UBS excluded positions related to the asset and liability management (ALM) portfolio from its regulatory VaR. The ALM desk is a treasury function within the Investment Bank which manages the funding and liquidity exposures of the Investment Bank and is not managed with trading intent. The positions related to ALM this portfolio remain in internal management VaR.

- 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 market risks associated with certain risk positions, as well as the revenue of large market movements for some trading positions.

Backtesting

The accuracy of the VaR model is monitored by backtesting, which compares the 1-day regulatory VaR calculated on trading portfolios at close of each business day with the actual revenues arising on those positions on the next business day. These backtesting revenues exclude non-trading components such as commissions and fees as well as estimated revenues from intraday trading. If backtesting revenues are negative and exceed the 1-day regulatory VaR, this results in a "backtesting exception".

VaR based on a one-day horizon provides an estimate of the range of daily mark-to-market revenues on trading positions under normal market conditions similar to those experienced during the historical period used in the model. As UBS's VaR model uses a look-back period of five years it does not respond quickly to periods of heightened volatility as experienced in 2008. When 1-day regulatory VaR is measured at a 99% confidence level, such an exception can be expected, on average, to occur on one in a hundred business days. More frequent backtesting exceptions may occur if market moves are greater than those seen in the look-back period, the frequency of large moves increases, or historical correlations and relationships between markets or variables break down (for example, in a period of extreme market disruption or an extreme stress event). Backtesting exceptions are also likely to arise if the way positions are represented in VaR does not adequately capture all their differentiating characteristics or the relationships between them.

UBS experienced 50 backtesting exceptions in 2008 compared with 29 backtesting exceptions in 2007.

The extreme market movements in a number of risk factors combined with a breakdown in traditional relationships between trading positions and their corresponding hedges (basis risk) were the primary contributors to the backtesting exceptions experienced. These results highlight the limitations of VaR and illustrate the need for multiple views of risk exposure such as macro and more targeted stress scenarios. Refer to the "Stress loss" section below for more information. UBS will continue improving its VaR model to better capture all relevant risks in its trading portfolio.

The first histogram on the previous page shows daily backtesting revenues in the Investment Bank for the whole of 2008. In the second histogram, the daily backtesting revenues are compared with the corresponding VaR over the same 12-month period for days when backtesting revenues were negative. A positive result in this histogram represents a loss less than VaR while a negative result represents a loss greater than VaR and therefore a backtesting exception.

All backtesting exceptions and any exceptional revenues on the profit side of the VaR distribution are investigated. In addition all backtesting results are reported to senior business management, the Group CRO and business division CROs.

Backtesting exceptions are also reported to internal and external auditors and relevant regulators.

Stress loss

The purpose of stress testing is to quantify exposure to extreme and unusual market movements. UBS's VaR measure is based on observed historical movements and correlations, whereas its stress loss measures are informed by past events but include forward looking elements. UBS's objectives in stress testing are to explore a wide range of possible outcomes, to understand vulnerabilities, and to provide a control framework that is comprehensive, transparent and responsive to changing market conditions.

In light of the continued dislocation in financial markets, UBS has placed less emphasis on statistical models such as VaR for the identification and management of risks and more on its stress-based measures, particularly to identify and manage those portfolios considered most at risk.

In 2008, UBS continued to enhance its Group-wide stress testing framework, with a particular focus on the development of a range of concrete, detailed forward-looking stress scenarios. Each scenario is based on the premise of a large initial shock occurring in one part of the financial markets, leading to a series of subsequent shocks in other markets. The scenario specifications are explicitly intended to capture the liquidity characteristics of different markets and positions. More frequent review of the range of scenarios in the context of macroeconomic risk analysis has also been initiated.

Standard scenarios are recalculated daily, allowing the development of stress loss exposure to be tracked and comparisons made from one period to the next. Stress loss limits approved by the Board of Directors are applied for all business divisions. Additional requirements for stress scenario calculation capabilities are being established for all Investment Bank trading systems.

Specific or "targeted" stress scenarios focusing on current concerns and vulnerabilities are also used. These measures are adapted to changing market conditions, as well as changes to UBS's portfolios, sub-portfolios and positions. The choice of scenarios depends on management's view of potential economic and market developments and their relevance to UBS's risk exposures. Targeted stress measures also feed into UBS's earnings-at-risk and capital-at-risk metrics.

The VaR results beyond the 99% confidence level are analyzed to better understand the potential risks of the portfolio and to help identify risk concentrations. The results of this analysis are valuable in their own right and can also be used to formulate position-centric stress tests. Although the standard scenarios incorporate generic elements of past market crises, more granular detail of specific historical events is provided by extreme VaR outcomes. The largest possible loss arising from UBS's daily VaR simulation using five years of historical data is also monitored against limits as an additional stress scenario.

UBS applies country limits to all but the best-rated countries, covering market as well as credit risks. This includes applying appropriate stress loss limits to emerging markets in aggregate as well as to individual emerging market countries.

The market moves envisaged in stress scenarios, including targeted stress scenarios, might prove to be less than the moves actually seen in a stress event, and actual events may differ significantly from those modeled in the stress scenarios.

Most major financial institutions employ stress tests, but their approaches differ widely and there is no benchmark or industry standard in terms of scenarios or the way they are applied to an institution's positions. The impact of a given stress scenario, even if measured in the same way across institutions, depends entirely on the make-up of each institution's portfolio, and a scenario that is relevant to one institution may have no relevance to another. Comparisons of stress results between institutions can therefore be highly misleading, and for this reason UBS, like most of its peers, does not publish quantitative stress results.

Concentration limits and other controls

UBS applies concentration limits on exposures to general market risk factors and to single name exposures. The limits take account of variations in price volatility and market depth and liquidity.

In the Investment Bank, limits are placed on exposures to individual risk factors. They are applied to general market risk factors such as interest rates, credit spreads, equity indices and foreign exchange rates or groups of highly correlated factors based on assumed moves in the risk factors broadly consistent with the terms of UBS's VaR measure. Each limit applies to exposures arising from all instrument types in all trading businesses of the Investment Bank. The assumed moves in risk factors are updated in line with the VaR historical time series and the limits are reviewed annually or as necessary to reflect market conditions. The effectiveness of risk factor limits in controlling concentrations of risk depends critically upon the way risk positions are represented. If long and short positions are considered to be sensitive to the same risk factor, potential gains and losses from changes in that factor are netted. The steps UBS has taken in 2008 to enhance the granularity of risk representation in its VaR measure are also relevant to its risk concentration controls as underlying relationships between risk factors are more clearly represented in VaR exposures.

UBS also applies volume-based limits to certain portfolios and sub-portfolios. Additionally, UBS measures and limits the potential impact of increased default rates on the value of its portfolio of single name exposures.

The Investment Bank carries exposure to single names, and therefore to event risk (including default risk). This risk is measured across all relevant instruments (debt and equity in physical form and from forwards, options, default swaps and other derivatives including basket securities) as the aggregate change in value resulting from an event affecting a single name or group. The maximum amount that could be lost if all underlying debt and equity of each name became worthless is also tracked. Positions are controlled in the context of the liquidity of the market in which they are traded, and all material positions are monitored in light of changing market conditions and information on individual names.

This form of single name exposure measure is most appropriate to corporate issuers, financial institutions and other entities, the value of whose equity and debt instruments is dependent on their own assets, liabilities and capital resources.

Exposures arising from security underwriting commitments are subject to the same measures and controls as secondary market positions. There are also governance processes for the commitments themselves, generally including review by a commitment committee with representation from business and control functions. Underwriting commitments are approved under specific delegated risk management and risk control authorities.

Other applications of market risk measures

Market risk measurement tools may be selectively applied to portfolios for which the primary controls are in other forms. VaR can, for example, provide additional insight into the sensitivity of investment positions to market risk factors, even though some of the assumptions of VaR - in particular the relatively short time horizon - may not be representative of their full risk. The results can be used by business management and risk controllers for information purposes or to trigger action or review.

Equity investments

UBS makes investments for a variety of purposes. Some are made for revenue generation or as part of strategic initiatives, while others, such as exchange and clearing house memberships, are held in support of UBS's business activities. Investments may also be made in funds managed by UBS to fund or "seed" them at inception or to demonstrate alignment of UBS's interests with those of investors. UBS has also bought and may be required to buy securities and units from funds that UBS has sold to clients. These include purchases of illiquid assets such as interests in hedge funds.

UBS may make direct investments in a variety of entities or buy equity holdings in both listed and unlisted companies. Such investments tend to be illiquid. The fair values of equity investments are generally dominated by factors specific to the individual stocks, and the correlation of individual holdings to equity indices varies. Furthermore, equity investments are generally intended to be held for the medium- or long-term and may be subject to lock-up agreements. For these reasons, they are not directly controlled using the market risk measures applied to trading activities. They are, however, subject to controls, including pre-approval of new investments by business management and risk control, and regular monitoring and reporting. They are also included in earnings-at-risk and capital-at-risk metrics.

Where investments are made as part of an ongoing business they are also subject to standard controls, including portfolio and concentration limits. Seed money and co-investments in UBS-managed funds made by Global Asset Management are, for example, subject to a portfolio limit. All investments must be explained and justified, approved according to delegated authorities, and monitored and reported to senior management throughout their life.

Private equity positions were, in the past, the major component of equity investments, but the portfolio has been managed down over recent years.

Under International Financial Reporting Standards (IFRS), equity investments may be classified as "financial investments available-for-sale", "financial assets designated at fair value through profit or loss" or "investments in associates".

Composition of equity investments

At 31 December 2008, UBS held equity investments totaling CHF 3,653 million, of which CHF 1,681 million were classified as "financial investments available-for-sale", CHF 1,079 million as "financial assets designated at fair value" and CHF 892 million as "investments in associates". Within "financial investments available-for-sale", CHF 258 million are listed equities.

At 31 December 2007, UBS held equity investments totaling CHF 7,690 million, of which CHF 3,583 million were classified as "financial investments available-for-sale", CHF 2,128 million as "financial assets designated at fair value" and CHF 1,979 million as "investments in associates". Within "financial investments available-for-sale", CHF 1,865 million are listed equities.

In December 2008, UBS disposed of its equity stake in Bank of China through a placing of approximately 3.4 billion Bank of China Limited H-shares to institutional investors for a cash consideration of approximately CHF 887 million (HKD 6,519 million). UBS acquired the shares in 2005 in preparation for Bank of China's IPO to the international market. The investment in Bank of China was accounted for as a "financial investment available-for-sale". The disposal resulted in a gain of approximately CHF 360 million.

Within the total of CHF 1,079 million "financial assets designated at fair value", CHF 1,058 million represents the assets of trust entities associated with employee compensation schemes. They are broadly offset by liabilities to plan participants included in "other liabilities". The equivalent positions at 31 December 2007 amounted to CHF 1,788 million.

Refer to "Note 34 Significant subsidiaries and associates" in the financial statements of this report for details of significant associates

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