Interest rate and currency management

Management of non-trading interest rate risk

UBS's largest non-trading interest rate exposures arise in our wealth management and Swiss-based banking business. These risks are transferred from the originating businesses into one of the two centralized interest rate risk management units – Treasury or the Investment Bank's Cash and Collateral Trading unit (CCT). They manage the risks on an integrated basis to exploit the full netting potential across risks from different sources.

Risks from all fixed-maturity, short-term Swiss franc and all non-Swiss franc transactions are generally transferred to CCT where they are managed within the market risk framework described in the Risk Management chapter under "Market risk".

Risks from Swiss franc transactions with fixed maturities greater than one year are transferred to Treasury by individual back-to-back transactions. Current and saving accounts and many other retail products of Global Wealth Management & Business Banking have no contractual maturity date or direct market-linked rate, and therefore their interest rate risk cannot be transferred by simple back-to-back transactions. Instead, they are transferred on a pooled basis via "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 behavior 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 regularly reviewed and adjusted as necessary. The originating business units are thus immunized as far as possible against market interest rate movements, but retain and manage their product margin.

A significant amount of 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. These risks are generally transferred to Treasury through replicating portfolios which, in this case, are designed to approximate the funding profile mandated by senior management.

Treasury manages its residual open interest rate exposures – taking advantage of any offsets that arise between positions from different sources – within its approved market risk limits (VaR and stress loss limits). The preferred risk management instrument is interest rate swaps, for which there is a liquid and flexible market. All transactions are executed via the Investment Bank – Treasury does not directly access the external market. Retained interest rate risk is included in the VaR shown in the table "Treasury: Value at Risk".

Market risk arising from management of consolidated capital

We are required, by international banking regulation (BIS regulations), to hold a minimum level of capital against assets and other exposures (risk-weighted assets). The relationship between our capital and our risk-weighted assets – the BIS Tier 1 ratio – is monitored by regulators and analysts and is a key indicator of our financial strength.

UBS's capital and many of its assets are denominated in Swiss francs, but the Group also holds risk-weighted assets in many other currencies, primarily US dollar, euro and UK sterling. Following the integration of Pactual in December 2006, we now also have material risk-weighted assets in Brazilian real. Any significant depreciation of the Swiss franc against these currencies would adversely impact the Group's BIS Tier 1 ratio. Treasury's mandate is therefore to protect this ratio against adverse currency movements and to generate a stable income flow from the capital. This mandate determines a currency, tenor and product mix – a target profile – against which Treasury manages the Group's capital.

The capital of the parent bank and its subsidiaries is placed in the form of interest bearing cash deposits internally within the Group – primarily with the Investment Bank's CCT unit. Where necessary Treasury also executes derivatives (mainly interest rate swaps) with the Investment Bank's trading desks to achieve the target profile. CCT and the derivative trading units manage the resultant cash and market risk positions as part of their normal business under the framework and limits described in the Risk Management chapter under "Market risk" and, in the case of CCT, within the liquidity framework described below under "Liquidity and funding management".

On an overall Group basis, Treasury's target profile is based on a currency mix which broadly reflects the currency distribution of the consolidated risk-weighted assets, using products and tenors which generate the desired income stream. As the Swiss franc depreciates (or appreciates) against these currencies, the consolidated risk-weighted assets increase (or decrease) relative to our capital. These currency fluctuations also lead to translation gains (or losses) on consolidation, which are recorded through equity. Thus our consolidated equity rises or falls in line with the fluctuations in the risk-weighted assets, protecting the Group's BIS Tier 1 ratio. The capital of the parent bank itself is held predominantly in Swiss francs in order to avoid any significant effects of currency fluctuations on its standalone financial results.

For the purposes of measuring and managing Treasury's market risk position, the Group's consolidated equity is represented in the Treasury book by replicating portfolios (liabilities) with the target currency and interest rate profile. The interest rate positions created by Treasury's deposits with CCT or other units, and the associated derivatives, generally offset the interest rate risk of the replicating portfolios but any mismatches between the two are managed, together with other non-trading interest rate risk positions within Treasury's market risk limits (VaR and stress), and are reflected in the table "Treasury: Value at Risk".

The structural foreign currency exposures are closely ­controlled by senior management but are not subject to internal market risk limits and are not included in Treasury's reported VaR.

Treasury interest rate risk development

In measuring Treasury's interest rate risk – expressed as VaR and shown in the table "Treasury: Value at Risk" – both the representation of the consolidated equity (replicating portfolios) and the deployment of the equity described above are included in the calculations. At 31 December 2006, UBS consolidated equity was deployed as follows: in Swiss francs (including most of the capital of the parent bank) with an average duration of approximately 3 years and an interest rate sensitivity of CHF 7.4 million per basis point; in US dollar with an average duration of approximately 4 years and sensitivity of CHF 8.4 million per basis point; in euro with an average duration of approximately 3 years and a sensitivity CHF 0.7 million per basis point; and in UK sterling with a duration of approximately 3 years and a sensitivity CHF 0.5 million per basis point.The interest rate sensitivity of these positions is directly related to the chosen duration – targeting significantly shorter maturities would reduce the apparent interest rate sensitivity but would lead to greater fluctuation in interest income.

Corporate currency management

Our corporate currency management activities are designed to limit and control the impact of adverse currency fluctuations on our reported financial results and on our ability to continue operations, given regulatory constraints. We specifically focus on three principal areas of currency risk management: match funding / investment of non-Swiss franc assets / liabilities; sell-down of non-Swiss franc profit and loss; and selective hedging of anticipated non-Swiss franc profit and loss.

Match funding and investment of non-Swiss franc assets and liabilities

As far as it is practical and efficient to do so, we follow the principle of matching the currency of our assets with the currency of the liabilities which fund them – thus a US dollar asset is typically funded in US dollars, a euro liability is offset by an asset in euros, etc. This avoids profits and losses arising from retranslation at the prevailing exchange rates to the Swiss franc at each quarter end.

Sell-down of reported profits and losses

For accounting purposes, reported profits and losses are translated each month from the original transaction currencies into Swiss francs at the exchange rate prevailing at the end of the month. Treasury centralizes profits (or losses) in foreign currencies that arise in the parent bank, and sells (or buys) them for Swiss francs in order to eliminate earnings volatility which would arise from retranslation at different exchange rates of previously reported non-Swiss franc profits and losses. Other UBS operating entities follow a similar monthly sell-down process into their own reporting currencies. Profits retained in operating entities with a reporting currency other than Swiss franc are managed as part of our consolidated equity, as described earlier in this section.

Hedging of anticipated future reported profits

The monthly sell-down process cannot protect UBS's earnings from swings caused by a sustained depreciation against the Swiss franc of one of the main currencies in which we earn net revenues or by an appreciation of one in which we incur significant net costs.

Our corporate currency management seeks to mitigate the potential adverse impact of any such developmentby executing a dynamic and cost-efficient hedge strategy on a portion of our anticipated future profits without losing the upside potential from a weakening Swiss franc.

The hedging program is developed and executed in the context of the risk tolerance defined by the Group Executive Board (GEB) and our view of likely currency movements, and is overseen and approved by the Group Chief Financial Officer. Although intended to hedge future earnings, these transactions are considered open currency positions. They are therefore subject to internal market risk VaR and stress loss limits and are included in the VaR shown in the table "Treasury: Value at Risk".

In our public segmental reporting, the profits and losses arising from the hedge strategy are shown as Corporate Center items, while the Business Group results are fully exposed to exchange rate fluctuations. For 2006, the net currency impact on UBS's Swiss franc financial net profit was slightly negative, but well within our agreed tolerances.