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Bond Pricing Service: Overview and Methodology

Bond Pricing Service: Overview and Methodology. CONTENTS. I. Introduction to the Mark-to-Market System II. Benefits of Bond Pricing III. Pricing Process Overview. 1.1 Introduction to the MTM System. Book Value Approach. Mark-To-Market Approach. Unchanged Value of Assets

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Bond Pricing Service: Overview and Methodology

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  1. Bond Pricing Service: Overview and Methodology

  2. CONTENTS I. Introduction to the Mark-to-Market System II. Benefits of Bond Pricing III. Pricing Process Overview

  3. 1.1 Introduction to the MTM System Book Value Approach Mark-To-Market Approach • Unchanged Value of Assets • Market change is not reflected • Deterioration of customers’ trust • Obstruction of market efficiency • Raise of market transparency, fairness and efficiency • Market change is reflected immediately • Compliance with higher risk management, compliance, reporting and audit requirements The Need for Bond Pricing • Only a few bonds are traded everyday While the total number of fixed income securities issued totals over 2,000, on average less than 100 of them (less than 1 % of the total), are traded daily and the transactions are concentrated on government bonds. • OTC market Unlike equities, It is difficult to obtain reliable price for fixed income securities since they are traded on the OTC market • Increasing sophistication of products The simple and inconsistent valuation methods as used now will not be sufficient to price and capture the risk of more complex structures going forward Therefore, there is a need for consistent and transparent valuation of the remaining 99% of the bonds to estimate their fair market value.

  4. 1.2 The Role of Bond Pricing The Need Daily valuation of bond portfolios for NAV calculation and regulatory compliance Utopia If all the bonds are traded at least once a day, we can use these prices for valuation, just like equity closing prices from Bursa Malaysia Dystopia There are no official published closing prices for bonds. Less than 1% are traded, where are the prices for the remaining 99%? Current method Quotes from brokers or banks, a few via internally generated models. The issue here is, how good are these prices? Are they verifiable? How are they derived? Do they meet accounting and risk management standards? The Solution BWM as a professional bond pricing provider evaluates about 1,600 bonds that are untraded on any given day, based on the market prices of about 50 bonds traded on the same day. BWM generates its fair price using market price data and other market information via various bond pricing models for different bonds. Since all PDS are different in their type by interest payment methods, principal payment methods, credit ratings, and embedded options, BWM needs to employ reliable database and evaluation methodology.This methodology is transparent and consistent.

  5. 2.0 Benefits of Bond Pricing for the Bond Market Revitalizing the Secondary Market for Bonds The majority of transactions are concentrated only on selected bonds, since the other bonds are seldom traded in the market due to the uncertainty of their fair values. Introducing proper valuation may revitalize the bond market by using the marked-to-market prices as benchmark by publicly announcing them. Also, marking-to-market system in bond pricing will promote more active management of bond portfolios held by financial institutions rather than passive hold-to-maturity strategies. Revitalizing the Primary Market for Bonds Many corporate bonds are seldom traded even if they have credit ratings, making the market price of the bonds uncertain. Therefore, from the origination and underwriting perspective, primary level pricing become very tricky especially for lower credits. Professional pricing on previously issued corporate bonds can promote new corporate bond issues by functioning as benchmarks for primary level pricing.

  6. 2.0 Benefits of Bond Pricing for the Bond Market Promoting New Product Development Once the valuation of more advanced products such as option-embedded bonds, reverse-FRN, etc, is well established, it will encourage more bond offerings and more active trading of these products in the secondary market. The pricing provider may also provide the market with the design and proprietary pricing models for these structured bonds. Improving Transparency & Specialization in the Investment Trust Industry Professional bond pricing will improve the standards of fund operation through consistent, systematic and transparent evaluation of their fixed income investments. This will indirectly enhance the standards of bond portfolio management and enable fairer evaluation of fund performance. The pricer also plays and important social role by promoting investor awareness of the products offered by investment trusts.

  7. 2.0 Benefits of Bond Pricing for the Bond Market Improving Soundness of Financial Institutions Professional fair valuation can also help increase the liquidity of assets and promote the discovery of fair value. This is in line with IAS 39 and Basle 2 requirements. For bonds held by these financial institutions, the effectiveness of risk management will be further enhanced as the valuation process will be consistent and not arbitrary

  8. 3.0 Pricing Process • BWM provides valuations on a daily basis at INDIVIDUAL bond level • A comprehensive data collection, validation, pricing and dissemination process is in place to ensure consistent and market neutral valuations • The bond pricing process is transparent and uses global standard pricing models • Full documentation is provided to clients • We incorporate a market feedback mechanism in the event there are disputes or queries on the prices • Interaction with the market via this feedback process is critical

  9. 3.1 Pricing Process Market study

  10. 3.2 Pricing Process Market study • Key Challenges at Security Master Level: • Granularity of Data • Specific Coupon Payment rules inconsistent with basic financial mathematics • Mudharabah / Murabahah valuation • Floating Rate Indices • Option valuations eg. Credit related and equity options • >4000 ISIN are Islamic PN/SN Structure • BIDS, FAST, term sheet and market conventions inconsistent • Poor disclosure of ABS pool information • Key Challenges at Trading Information Level • Market Churns • Private Placements (Primary & Secondary Info Issue) • Initial Issue Yield (for very illiquid bond) • Manipulation and errors in BIDS data

  11. 3.3 Pricing Process Example • Tekad Mercu Berhad • Trades in between Govt Guaranteed & AAA • Market prices up to initial expected maturity ie a simple Fixed Rate Bond with 5.25% Coupon • In reality Flipper Bermuda Callable Bond with 3 period (Fixed, Float, Float) + • Credit Default Derivative • Optionality is unpriced

  12. 3.2 Pricing Process Bond Pricing Approach Adopting the right pricing strategy corresponding to the unique environment of the Malaysian market is critical Market Maturity Market Maturity Liquid Secondary Market Large Pool of Market Participants Supply of Secondary Trading Instrument Hybrid Approach Risk Neutral Approach Structured Approach Hybrid Approach Informational Maturity Contents of the Information Access to the Information Information Maturity

  13. 3.2 Pricing Process Bond Price = f (Risk Free Interest Rate+ Credit Spread) 1. Derivation of Risk Free Curve Zero Coupon Yield Observed Trades Bootstrap Calibration Maturity 2. Derivation of Credit Spread for PDS Structural Model Merton type model Derived via Jarrow-Turnball type model Risk Neutral Model

  14. 3.3 Pricing Process Risk Neutral (Reduced Form) Model : Jarrow Type Credit Model Risk Free Yield Curve Credit Spread Prices Calibration Market Price is assumed to reflect the true value of the Bond. Recovery Value Apply to Bond Pricing Recovery Value is normally extracted from the disclosure of Rating Agency.

  15. 3.4 Pricing Process Structural Model : Merton Type Model Company Value Credit Spread Apply to Bond Pricing Measuring the Probability of Default Liabilities Stability Rating Agency Disclosure Measuring the Recovery Value Statistical Analysis

  16. 3.5 Pricing Process Our bond pricing methodology is based on a Hybrid Approach combining the Structural and Risk Neutral models given the state of the Malaysian bond market Concurrently, BWM is undertaking a comprehensive on-going effort to improve the quality and granularity of information (e.g securities master, trading data etc)

  17. 3.6 Pricing Process In simple terms, BWM uses the prices of observed trades in the market to derive the prices of untraded bonds, taking into account the differences between different issuers and structures. Therefore, EVERY bond has its own individual spread relative to its credit class Background Study Daily Process Define Matrix Segmentation Classes Populate into segments Build yield curves Assign Individual Spreads Price ALL bonds Other studies: Credit scoring of issuers within industry Apply filtration and watch bond rules • Derivation of individual • spread for PDS via: • Application of credit • score • Structure • Size • Observation from past • trades • Market and macro • Economic factors Feedback and Verification with market Any trading data RISK NEUTRAL MODEL ELEMENT STRUCTURAL MODEL ELEMENT

  18. Yield curve(AA) Spread(AA) Base yield curve (AAA) 3.7 Pricing Process Pricing of bonds that are untraded or rarely traded • Obtain a base spread from the past real transaction data • Track the change of spread over time • Estimate the spread of the bond relative to changes in the yield curves and other benchmarks Y i e l d 20bp Evaluation Yield Real Transaction Spread of specific bond 20bp 15bp 15bp Evaluation Date Term to Maturity

  19. 3.8 Pricing Process Bond types priced by BWM: Callable Amortizing Bonds with Secondary Notes Discount Bond Bullet Bond Fixed Rate Bond Amortizing Bond Callable Bond Convertible Bond Exchange Bond Bond with Warrants Fixed Rate ABS Callable ABS Fixed Rate MBS Callable MBS Stepping FRB Floating Rate Note Floating Amortizing Note Floating Rate ABS Floating Rate MBS Bond with Secondary Notes Amortizing Bond with Secondary Notes Callable Amortizing Bond Stepping Amortizing Bond Callable Stepping Bond Callable Stepping Amortizing Bond Convertible Stepping Bond Callable Bond with Secondary Notes Convertible Bond with Secondary Notes As of Feb 2006: Total stocks in the market: 2440 Priced by BWM: 1723 Not priced by BWM: Not rated or short term issues eg CP and Bills 426 Loan stocks and Notes 291

  20. 4.0 Delivery Channels 3 different delivery modes to suit client’s requirements BONDSTREAM PRICING TERMINAL Excel download BWM Daily Valuations 5 pm KL WEB DOWNLOAD csv file download DIRECT DATA FEED File to file transfer direct into client’s system

  21. THANK YOU To find out more on what we can do for you, contact our Market Development Team at: Tel: +603 2711 5122 Fax: +603 2284 1807 Email : enquiries@bondweb.com.my

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