Market Risk

Market risk is incurred primarily through UBS’s trading activities, which are centered in the Business Group Investment Bank.

Market risk for the Investment Bank, as measured by the average 10-day 99% Value at Risk (VaR) fell in second quarter 2004 from first quarter 2004. The gradual decrease in VaR over the quarter, which can be seen in the backtesting revenue and VaR graph on the next page, reflected a deliberate response to market uncertainty in the face of increased concerns about inflation, the spike in oil prices, which reached their highest levels for 20 years in May 2004 and reduced market opportunities, particularly towards the end of the quarter.

Credit spread exposures remained the main risk driver for Investment Bank VaR. This quarter, changes in inventory composition combined with decreased credit spread exposures drove interest rate and total VaR down. The increase in VaR for the “other” risk class resulted from refinements to the VaR model for the energy trading business. The impact of this model change on total VaR was minimal, as the correlation of energy risk to our main risk drivers, interest rates and equities, typically tends to be low. This also explains the increase in the diversification effect shown in the breakdown of VaR by risk type in the table above. Equity average VaR remained broadly unchanged, but ended the quarter slightly up from the end of first quarter 2004.

“Backtesting” compares actual revenues arising from closing positions (i.e. excluding intraday revenues, fees and commissions) with the 1-day VaR calculated on these positions, and is used to monitor the quality of the VaR model. The graph shows these daily revenues and the corresponding 1-day VaR over the last 12 months. The 10-day VaR, which is the basis of the limits and exposures in the tables above, is also shown in this graph for information. Revenue volatility over the period was within the range predicted by the VaR model. The gains at the beginning of second quarter 2004 can be attributed to price declines in treasury bonds, following a stronger than expected March US jobs report, which prompted yields to rise and the USD to strengthen on speculation that the Fed might have to consider raising rates.

We routinely assess and actively manage / control portfolio tail risks against a standard set of forward-looking scenarios supplemented by specific scenarios targeting individual sectors or reflecting current concerns, such as increasing interest rate levels. Stress events modeled in our standard scenarios include crises in equity, corporate bond and emerging markets, and severe movements in currency, interest rate and energy markets. These scenarios are kept under constant review and fine-tuned as necessary. Like VaR, stress loss exposure ended the quarter lower than at the previous quarter end. The average was also lower and exposure remained within the approved limits.

We also apply concentration controls on exposure to individual market risk variables, such as individual equity markets, currency interest and foreign exchange rates, and single-name issuers. The avoidance of undue risk concentrations remains a key pillar of our risk control process.

Change in VaR model

Over the past two years, growth in asset-backed securities has outpaced other sectors in the fixed income markets. At the same time, our Investment Bank’s market share in this sector has grown, leading to an increase in exposure. To date these exposures have been represented as corporate AAA securities in VaR, leading to an overstatement of credit spread risk, and a larger gap between our backtesting revenues and VaR than would generally be expected.

To better reflect the risk in VaR, we have increased the granularity of our risk representation of such securitized products. In July 2004, the Swiss Federal Banking Commission (SFBC) gave their approval for this change and we will implement the revised model during third quarter. As a result, the VaR number reported for the Investment Bank is expected to decline notably, with 10-day VaR potentially falling by more than 20% depending on exposures actually carried. A retrospective analysis of the impact of the new model will be published prior to third quarter 2004 results.

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