What is a Bond Pricing Agency

Bond Pricing Agency ……In the overall scheme of things,

now and across the horizon

©Copyright BONDWEB MALAYSIA SDN.BHD. - All rights reserved.

RAM Economic Series June 200820 June 2008

Meor Amri bin Meor Ayob


Fundamentals of the Market

The Full Circular Flow

� Goods and services

� Buyer And Seller

� Medium Of Exchange

� PRICE

Money

Resources (Input)

Production and People


Money

Goods and Services

(Output)

Distribution (Consumers)

AGENDA

� Bond Market Growth in Malaysia

�What Is A Bond Pricing Agency

� Introducing Bondweb Malaysia Sdn Bhd

� Pricing Methodology

�Bond Pricing, Current Practice and Pricing Issues

The purpose of today’s presentation is to discuss on current bond pricing mechanisms and its application now and in the future.



Bond Market Growth in Malaysia

The Malaysian bond market has seen tremendous growth over the past years

� Private Debt Securities (PDS) emerged as the largest source of private sector financing in the aftermath of the 1997 financial crisis

� It was reported that Malaysia’s Islamic bond market grew over 80% over the last 5 years, with a 96% y-o-y growth in long term PDS market for the year 2007

� Malaysia accounts for two thirds of global Islamic bonds outstanding in 2007


* Long term PDS are notes that are above 1 year in tenure and would naturally exclude commercial papers, BNM notes, repos and other related papers

96% y-o-y

growth in

Islamic

PDS

2007

� Binariang GSM’s Senior Islamic bond issuance worth RM20 billion is the largest corporate bond issue in Malaysia yet


Activity in the secondary market has been consistent

� Despite the growth in bond issuances, liquidity and activity in the secondary market has not grown in tandem

� Liquidity has been observed to be active for better credit quality papers

� Key issue in the lack of liquidity is price and information transparency


Pricing Process

Bond types identified and priced by BWM in the MYR market:

�Discount Bonds�Bullet Bonds�Fixed Rate Bonds�Amortizing Bonds�Callable Bonds�Convertible Bonds�Exchange Bonds�Bond with Warrants�Fixed Rate ABS�Callable ABS�Fixed Rate MBS�Callable MBS�Stepping FRB�Floating Rate Notes

�Convertible Bonds with Secondary Notes�Callable Amortizing Bonds with Secondary Notes�Stepping Amortizing Bonds with Secondary Notes�Callable Discount Bond�Callable Convertible Discount Bond�Callable Stepping Bonds with Secondary Notes�Exchangeable Stepping Bonds

As of June 2008Total stocks in the market: 2717

Total stocks priced by BWM: 1930


�Floating Rate Notes�Floating Amortizing Notes�Floating Rate ABS�Floating Rate MBS�Bond with Secondary Notes�Amortizing Bonds with Secondary Notes�Callable Amortizing Bonds�Stepping Amortizing Bonds�Callable Stepping Bonds�Callable Stepping Amortizing Bonds�Convertible Stepping Bonds�Callable Bonds with Secondary Notes


A number of Islamic concepts have been applied in the structuring of Islamic bonds

� Islamic concepts applied in various bonds :

�Al Bai BithamanAjil�Al Qardhul Hasan�Bai' Bi Al-Taqsit�Bai Dayn�Bai Dayn & Murabahah�Bai-Al-Einah�Ijarah�Istisna�Mudharabah�Murabahah�Musyarakah


�Musyarakah

� Combinations include:�Al Bai BithamanAjil & Bai Einah�Mudharabah & Murabahah�Murabahah & Bai Al Dayn�Murabahah & Musyarakah�Murabahah & Ijarah�Istisna & Mudharabah

AGENDA









What Is A Bond Pricing Agency

A bond pricing agency (BPA) is a market neutral entity whose role is to provide fair valuations on bonds, complying with regulations issued by the Securities Commission

The Solution

�The BPA evaluates about 2,000+ bonds that are not traded on any given day, based on the market prices

�The BPA needs to employ reliable database and evaluation methodology. This methodology MUST be transparent and consistent

Problem

Less than 1% are traded, where are the prices for the remaining 99%?

The Need

Daily valuation of bond portfolios for NAV calculation and portfolio valuation


consistentcalculation and portfolio valuation

Current method

Quotes from brokers or banks, a few via internally generated models – bias?

Increase Transparency

Increase Liquidity

Managing & Monitoring Risk

Compliance & Audit

BPA


BOND NAME VALUE DATE MTM PRICE MTM YIELD

LAST TRADE

PRICE

LAST TRADE

YIELD LAST TRADE DATE

MGS 1/1987 7.600% 15.03.2008 22-Feb-08 100.25 3.27 100.33 3.47 13-Feb-08

MGS 2/1988 6.450% 01.07.2008 22-Feb-08 101.1 3.29 101.2 3.29 05-Feb-08

MGS 4/2003 3.917% 30.09.2008 22-Feb-08 100.37 3.3 100.39 3.29 05-Feb-08

MGS 3/1988 6.450% 30.11.2008 22-Feb-08 102.37 3.31 102.7 3.7 22-Nov-07

MGS 6/1998 7.005% 10Y 15.12.2008 22-Feb-08 102.92 3.32 104.98 3.41 06-Jul-07

KLIA 7.750% 17.01.2015 PN 22-Feb-08 121.82 4.09 121.06 5.45 04-Mar-02

GII 1/2003 0.00000% 31.03.2008 22-Feb-08 99.66 3.31 98.58 3.56 31-Oct-07

GII 3/2004 0.00000% 29.10.2009 22-Feb-08 94.4 3.45 86.93 4.15 24-May-06

GII 2/2004 0.00000% 30.09.2011 22-Feb-08 88.03 3.57 103.2 0 09-May-07

©Copyright BONDWEB MALAYSIA SDN.BHD. - All rights reserved.©Copyright BONDWEB MALAYSIA SDN.BHD. - All rights reserved.

GII 2/2004 0.00000% 30.09.2011 22-Feb-08 88.03 3.57 103.2 0 09-May-07

SMC 7/2003 11.04.2008 22-Feb-08 100 3.43 99.98 3.53 31-May-07


BPAs are new entities and currently only three countries use the BPA framework

Mexico

Korea

Egypt (in development)Thailand


Korea

�Korea Bond Pricing�KIS Pricing, Inc�NICE Pricing Services, Inc

Malaysia

�Bondweb Malaysia Sdn BhdMexico

�Two price vendors under the purview of Banco De Mexico

MexicoMalaysia

Indonesia (in development)

Egypt (in development)

Thailand

�Thai Bond Market Association (SRO)


BPAs are an important infrastructure to a country’s capital market in particular to emerging markets where there is uncertainty in fair valuations and illiquidity. Key benefits include:

Revitalizing the

Secondary

Market for Bonds

�BPA valuation approved by the SC may revitalize the bond market using mark-to-market prices as benchmark by publicly announcing them

�Marking-to-market system provide strategy alternatives to traditional hold-to-maturity strategies.

Revitalizing the

Primary Market

for Bonds

�From an origination and underwriting perspective, primary level pricing becomes challenging especially for lower credits

�Mark-to-market pricing on previously issued corporate bonds can promote new corporate bond issues by functioning as benchmarks for primary level pricing


Promoting New

Product

Development

�BPA’s transparency in the methodologies being used will spur the evolution of the bond market with further advance pricing methodologies

�When advance pricing methodologies are established, it will encourage more bond offerings and more active trading of these products in the secondary market.

Improving the

Soundness of

Financial

Institutions

�Providing price discovery may assist in financial institutions' compliance to international standards such as IAS 39 and Basel 2 requirements.

�Effectiveness of risk management will be further enhanced as the valuation process will be consistent and not arbitrary

AGENDA









Introducing Bondweb Malaysia Sdn Bhd

Bondweb Malaysia (BWM) was incorporated in 2004. We are the pioneering BPA for the Malaysian market.

Under the purview of the Securities Commission

�Appointed as a BPA by the Securities Commission on April 18, 2006

�Met and exceeded the requirements as outlined in the Guidelines on the Registration of Bond PricingAgencies

Fair valuation for the Ringgit bond market

�Provides independent daily valuations for approximately 2000 MYR fixed income securities

�A one-stop comprehensive bond information service provider


An emphasis on market relevant pricing

�Alliances with local business partners ensure speedier capturing of price discovery than any availablesource.

�Help facilitate finer price discovery hence spurring trading activity that enhances risk management andoptimises capital allocation

�Bondweb user demographics includes Banks, Unit Trust and Asset Managers, Insurers, GovernmentAgencies and Corporations


Vision and mission of Bondweb Malaysia Sdn Bhd

��To create an open and low cost bond market To create an open and low cost bond market

information exchange platform accessible to all information exchange platform accessible to all

market players and optimised to local needsmarket players and optimised to local needs

��To provide a consistent and systematic bond fair To provide a consistent and systematic bond fair

valuation infrastructure currently lacking in the valuation infrastructure currently lacking in the

Malaysian fixed income marketMalaysian fixed income market

��To provide a forum and platform for all market To provide a forum and platform for all market

participants on market issues and newsparticipants on market issues and news


participants on market issues and newsparticipants on market issues and news

��To participate with the market in enhancing the To participate with the market in enhancing the

standards of pricing, trading and structuring fixed standards of pricing, trading and structuring fixed

income instrumentsincome instruments

Participating in the fostering of the bond market’s advancement


BWM was established in 2004

�A market neutral joint venture providing bond pricing and information services between:� Rating Agency Malaysia Consultancy Sdn Bhd� Mainstream and Co., Ltd (Korea)� Lembaga Tabung Angkatan Tentera (LTAT) � UTIX Sdn Bhd (Usaha Tegas)� PacificMas Berhad� Malaysian Trustees Berhad

�With participation from:� MARC on data and technical support � SC and BNM in observer and advisory role� Market community (buy/sell side, brokers) via

Began groundwork in MalaysiaDiscussions with SC and BNMMarket study and research

2001

-

2004

Sept: Bondweb Malaysia Sdn Bhdestablished

2004

March: BWM website launchedJuly: Bondstream pilot launchSept: Full marked-to-market processOct: Commercial deployment of

Bondstream

2005


� Market community (buy/sell side, brokers) via “Bottom Up” approach

�Adhered to strict SC requirements to qualify as BPA:� Audited methodology and process� Three months market acceptance test� RM10 million minimum paid up capital and professional indemnity insurance

� No controlling shareholdersStatus as at June2008:

> 70 clients (banks, AMC, UTMC, insurance companies, corporate, quasi governments)

April 18: Appointed Malaysia’s first BondPricing Agency

2006

January 3 : Guidance Note 15 on Mandatory use of BPA prices by unit trust companies2007




BWM’s Pricing Services

�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

�The models are customised to meet the unique needs of the Malaysian market

�BWM prices unlisted MYR bonds (Conventional and Islamic). For now we do not price short term papers,

3 different delivery modes to suit clients’ requirements

BondStreamPricing Terminal

� Excel download

BWM Daily

Valuations


Islamic). For now we do not price short term papers, unrated bonds, loan stocks and listed bonds

�We incorporate a market feedback mechanism in the event where there are disputes or queries on the prices

�Intimate local knowledge of the instruments and market structure is vital to ensure credibility of the BPA

Web DownloadDirect Data Feed

� CSV file download� File to file transfer

direct into client’s

system

6 pm KL

Product Lines

Optimised to the needs of market participants

1) Fair Valuation - Daily MTM prices/yields

2) Bond Information- Primary Market Data- Secondary Market Data

3) Reference Pricing Service


Launched in

2005


3) Reference Pricing Service

4) Bond Index

5) Basel II Support Pack

6) RBC Support Pack

7) Customized Data Delivery

Launched in

2008


Delivery Channels – bond information portal at www.bondweb.com.my

�News and Research� Market News

� Market Research from

local and international

research houses

�Community� Market Opinion� Market Commentary

�Primary Market� Facility Information

� Stock Information

�Secondary Market� Daily Trading

� Trade Statistics

� Trading Charts

� Historical Data

�Yield Analysis� Yield Matrix� Yield Curve

�Other Market Information� Money Market

� Equity Market


� Stock Information

� Issuer Financial

Information

� Credit Rating Information

� Issue Statistics

� Tender Information

� Equity Market

� FX market


Delivery Channels – custom designed software tool BondStream

�Bond Database� Stock Info� Facility Info� Rating Info� Bond Statistics � Statistics database� Corporate info database� Islamic bond data

�Trading data� Real-time Quotes� Daily trading activity� Historical trades back to 2000

�Analysis Tools� Bond Analysis Tools� Bond Calculator� W.I Simulator� Favourite bonds� Bond Advanced Search� Bond Trade search� Custom Report generator

�Charting� Real-time quote charts� Daily charts� Yield curves� Technical analysis tools


2000� Trade map� Market depth

�Fair Valuation� Daily MTM prices for MYR unlisted bonds

� YTM matrices on Conventional and Islamic bonds

� Technical analysis tools

�Market Data� Indicative Money Market rates

� Research and commentaries

� Real time news

AGENDA









Pricing Methodology

Bond Pricing Approach – Current Industry Practice and the Assumptions

YTM Matrix /

Curve Pricing

Individual

Quotation

Approach

Four common market practices are used in conducting bond pricing. BWM employs the hybrid approach

Approach Type Pricing Method Granularity

YTM Matrix / Curve Pricing

Quote Driven Curve Pricing

Individual Quotation Approach

Quote Driven Individual Bond

Model Approach Theoretical Individual Bond


Model Approach

(Mark To Model)

Hybrid Approach

Model Approach Theoretical Individual Bond

Hybrid Approach Hybrid Individual Bond

Pricing Methodology


YTM Matrix /

Curve Pricing

Individual

Quotation

Approach

Assumptions:

1y 2y 3y …

AAA

AA

A

BBB

1y 2y 3y …

AAA 3 4 5 …

AA 3.5 4.5 … …

A … … … …

BBB … … … …

Quoted Bonds

Marking to

market


Model Approach

(Mark To Model)

Hybrid Approach

1.Market Liquidity/Efficiency

�Contributed Quotations are assumed to be an unbiasedmarket representation.

�Market is liquid without seasonal effects.

2.Homogeniety

�Bonds belonging to the same segment are assumed identical.

Pricing Methodology


YTM Matrix /

Curve Pricing

Individual

Quotation

Approach

Assumptions:

Traded BondsQuoted Bonds

M

a

p

M

a

p

Marking to

market


Model Approach

(Mark To Model)

Hybrid Approach

1.Market Liquidity Efficiency

�Contributed Quotations are assumed to be an unbiasedmarket representation.

�Selective Group of Contributors monitor individual bond value on an on-going basis.

�Individual bonds are assumed to be liquid, where the value of individual bonds are observable.

Pricing Methodology


YTM Matrix /

Curve Pricing

Individual

Quotation

Approch

Assumptions:

� Financial Data� Interest Rate Data� Asset Value� Asset Volatility� Recover Rate� Risk Free Rate� Curve Rate

� Liquidity Model� Credit Scoring Model� Term Structure Model

A

n

a

l

y

t

i

c

s

A

n

a

l

y

t

i

c

s

Marking to

market


Hybrid Approach

Model Approach

(Mark To Model)

1.Model Is Winner

�Mathematical model generates price�Underlying information is accurate and timely

Pricing Methodology


YTM Matrix /

Curve Pricing

Individual

Quotation

Approch


Hybrid Approach

(BWM’s Approach)

Model Approach

(Mark To Model)

�Back-test representation of market value by marking to model shows inaccuracies with actual market trades

�Market is winner not model

Assumptions:

Pricing Methodology


YTM Matrix /

Curve Pricing

Individual

Quotation

Approch

Traded Bonds

Quoted Bonds

Calibrating

Implied

Risk Premium

From Market

DataPre and

Post Data

Pool

Marking to

market


1. Market Liquidity/Efficiency

�Market is not liquid, trade frequency is low. Still, trade prices (if properly monitored) can provide information for pricing.

2. Credit Model

�Mathematical Model does not provide market price.�Mathematical Model provides the framework to derive the risk premium/spread in the market. Selective Group of Contributors monitor individual bond value on an on-going basis.

Model Approach

(Mark To Model)

Hybrid Approach

Liquidity risk model

Credit risk model

Term structure model

Pricing Methodology

BWM’s Pricing Methodology – An Overview

Bond Price = f ( Benchmark Rates + Credit Spread )

Credit RiskLiquidity

Risk

Risk

Y

i

e

l

d

Term to Maturity

Derivation of benchmark rate


Measuring the

Market Price

Of Risk

Segmentation Cube

Individual Bond

Valuation

Trades

Quotations

Individual Bonds

A daily process is conducted to price all bonds

Pricing Methodology

Daily ProcessBackground Study

Define Matrix

Segment Classes

Populate Info

Into Segments

Build Yield

Curves

Assign

Individual

Spread

Derivation of individual spread for PDS via:�Application of

Segmentation Analysis

Apply filtering andwatch list rules

Feedback and Verification with

market

Price All Bonds


�BWM uses the prices of observed trades & quotations in the market to derive the prices of non-traded bonds, taking into account the differences between different issuers and structures.

�EVERY bond has its own individual spread relative to its risk status.

credit score�Structure�Industry�Observation from past

�trades

Any trading data

Trade DataAggregation

Pricing Methodology

Define Matrix Segment Classes

Data is segmented into classes and ranked according to its credit quality and liquidity performance

Macro Segmentation

� Credit Rating/Issuer Type

Micro Segmentation

Individual BondsIssuer Ranking

Evaluating Risk at Individual Bond Level


� Credit Rating/Issuer Type� Industry�Product Structure Characteristic� Liquidity

Ranking bonds based on credit analysis

and scoring

�Accounting-based Models (Altman’s type)�Market-based Models (Structural model)

Ranking bonds based on market liquidity

�Turnover�Trade frequency

Pricing Methodology

Populate Info Into Segments

Data is extracted and mapped to the proper segments

Official Sources

Market Network

Term Sheet,

ETP

FAST

Ratings

BWM Internal Process Data Population

Macro Segment

Term sheet

Enhancement

Model

Selection


Term Sheet, Validation

Broker Quotes

Pricing Convention

Swap Yields Micro Segment

Trade Data

Enhancement

Key challenge in data aggregation is

�To collect accurate post and pre trading data.

�To enhance and update securities information on-going basis


Pricing Methodology


Y

I

E

L

D


Pricing Methodology

Outliers from normal trade band

Issues

Solution

Data Filtering will identify trades and quotes that are not representative of current market levels


Term to

Maturity

�Out of Credit Rule�Liquidity Rule�Assignment of Confidence Interval

�Relative Movement against�General Market Direction

Filtering Rule

Calibrating Risk Free Curve from MGS

Zero Coupon

YieldMaturity

Bootstrap

Calibration

MGS Data

Build Yield Curves

Pricing Methodology

Using the filtered data, calibrate risk free and credit curves for MGS and PDS


Calibrating Credit Curve for PDS

YieldMaturity

PDS Data

Calibrating Risk Premium by

each Segment MaturityCredit

Curves

Pricing Methodology

Government Bond Pricing

Market Info

�Post-trade info from ETP

�Pre-trade info money brokers

�Pre-trade info bank contributions

Y

i

e

l

d

Gather Required Gather Required

InfoInfo


InfoInfo

First First

FilteringFiltering

First First

FilteringFiltering

Generation Generation

of Spot Yield of Spot Yield

CurveCurve



CurveCurve

Validation Validation

of Resultof Result


of Resultof Result


d

Term to Maturity

Exclude Unusual Trades

�Cross Trades

�Odd Lots

�Off Market

�Position Parking


InfoInfo


InfoInfoFirst FilteringFirst FilteringFirst FilteringFirst Filtering



CurveCurve



CurveCurve


of Resultof Result


of Resultof Result

Y

i

e

l

d


Pricing Methodology


�Position Parking

Exclude Outliers

�Compared to historical trades and quotes

�Compared to past evaluated yield

d

Term to Maturity

Generate YTM Curve

�Zero curve is not directly observable from the market

Obtain Zero Rate From YTM Rate


InfoInfo


InfoInfo

First First

FilteringFiltering

First First

FilteringFiltering

Generation of Generation of

Spot Yield Spot Yield

CurveCurve

Generation of Generation of

Spot Yield Spot Yield

CurveCurve


of Resultof Result


of Resultof Result

Y

i

e

l

d


Pricing Methodology


Obtain Zero Rate From YTM Rate

�Reflect the differences of practices in yield calculation (“practices” mean compounding period, day count basis, etc.)

�Standardise to semiannual basis ACT/ACT

�Bootstrap

d

Term to Maturity

Loop Back Test

�Calibrate YTM / Zero curve to ensure MTM values are market relevant


InfoInfo


InfoInfo

First First

FilteringFiltering

First First

FilteringFiltering



CurveCurve



CurveCurve

Validation of Validation of

ResultResult

Validation of Validation of

ResultResult

Y

i

e

l

d


Pricing Methodology


d

Term to Maturity

Data Population Data Population

Into SegmentInto Segment



First First

FilteringFiltering

First First

FilteringFiltering

Credit Credit

Spread Spread

Curve Curve

GenerationGeneration

Credit Credit

Spread Spread

Curve Curve


ValidationValidationValidationValidation

Y

i

e

l

d

PDS Credit Curve

Pricing Methodology

Market Info

�OTC trading

�Money brokers


d

Term to Maturity

� Segmentation Cube

Exclude Unusual Trades

�Cross Trades

�Odd Lots

�Off Market

�Position Parking

First FilteringFirst FilteringFirst FilteringFirst Filtering



CurveCurve



CurveCurve


of Resultof Result


of Resultof Result

Y

i

e

l

d

PDS Credit Curve

Pricing Methodology






�Position Parking

Exclude Outliers

�Compared to historical trades and quotes

�Compared to past evaluated yield

�Out of credit rule

d

Term to Maturity





First First

FilteringFiltering

First First

FilteringFiltering

Credit Spread Credit Spread

Curve Curve


Credit Spread Credit Spread

Curve Curve


ValidationValidationValidationValidation

Y

i

e

l

d

PDS Credit Curve

Pricing Methodology

Credit Curve

�Derive from trade prices in segment

�Risk free yield from MGS curve

Credit Spread Rule


d

Term to Maturity

Credit Spread Rule

�Spread along the maturity

�Spread by size of riskRisk Free Yield

Now that the curves are ready, assign individual spread that reflects the bond’s appropriate risk according to the result from the ranking model

Y

I

E

L

DRisk free interest

rate curve1

Credit class

curves2Credit risk spread

from risk free2i

Y

I

E

L

D

Bond A

Bond B

Bond C

Bond D

Bond E

Assign Individual Spread

Pricing Methodology

©Copyright BONDWEB MALAYSIA SDN.BHD. - All rights reserved.©Copyright BONDWEB MALAYSIA SDN.BHD. - All rights reserved.

Term to Maturity Term to Maturity

Tenor t

Curve YTM at Tenor t

Positive

Spread

Negative

Spread

Bond

C

Bond

A

Bond

B

Bond

D

Bond

E

Bond Price

= f (Risk Free Interest Rate , Risk Spread)

Risk Spread

= f (Credit, Individual)

Notation Descriptionsf Coupon payment frequency in a yearc Coupon rateF Face amount = Notionaly Yield *AI Accrued InterestD No. of days in one regular coupon

periodD2 No. of days between the value date and

the next coupon Daten Last coupon periodE / U No. of days between the pseudo issue /

real last coupon date and the real first coupon / pseudo maturity date (short first / last coupon)

Pricing Methodology

Price All Bonds

AI

f

y

F

f

y

fF

c

DDn

n

k DDk

−

×+

+

×+

××

+−=+−

∑)21(1

)21(

)1

1001()

1

1001(

1

100

Eg1 : Fixed coupon bonds with regular period

Eg2 : Fixed coupon bonds with short first coupon

AIFf

Fc

E

FIF

fF

cn

−+

××

+

×××

∑

1

100

1

100

Apply relevant bond type price formula


* Price computed using yield derived from the (credit spot rate at discount period t + individual spread)

first / last coupon)

No. of days between the pseudo issue / pseudo last coupon date and the pseudo first coupon / pseudo maturity date (long first coupon)

FIF / LIF No. of days between the real issue date / real last coupon and the real first coupon / real maturity date(Short First / Last Coupon Bond)

No. of days between the real issue / pseudo last coupon date and the pseudo first coupon / real maturity date (Long First / Last Coupon Bond)

AI

f

y

f

y

f

yE

Dnk E

DkE

D−

×+

+

×+

+

×++−

=+−

∑)21(

2)21(2

)1

1001()

1

1001()

1

1001(

AI

f

y

F

f

y

U

LIF

fF

c

f

y

fF

c

UD

U

LIFn

UD

U

LIFn

n

k DDk

−

×+

+

×+

×××

+

×+

××

++−++−

−

=+−

∑)21()21(

1

1)21(

)1

1001()

1

1001(

1

100

)1

1001(

1

100

Eg3 : Fixed coupon bonds long first coupon

Notation Descriptionsf Coupon payment frequency in a yearc Coupon rateF Face amount = Notionaly Yield *AI Accrued InterestD No. of days in one regular coupon

periodD2 No. of days between the value date and

the next coupon Daten Last coupon periodRPi Remaining principal at future time ti

Current/forward coupon rate following convention

Pricing Methodology

Price All Bonds

Eg4 : Stepping Bonds

Eg5 : Amortizing Bonds

Apply relevant bond type price formula

AI

f

y

F

f

y

fF

c

DDn

n

k DDk

k

−

×+

+

×+

××

+−=

+−∑

)21(1

)21()1

1001()

1

1001(

1

100

AIRPf

RPc

nn k

−+

××

∑

1

100

−

tIndex


* Price computed using yield derived from the (credit spot rate at discount period t + individual spread)

Eg6 : FRN

AI

f

y

RP

f

y

f

DDn

n

k DDk

−

×+

+

×++−

=+−

∑)21(

1)21(

)1

1001()

1

1001(

100

AI

f

y

F

f

y

fF

ndexI

f

y

fF

c

DDn

n

k DDk

t

DD

−

×+

+

×+

××

+

×+

××

+−=

+−∑

)21(2

)21(

_

)2()1

1001()

1

1001(

1

100

)1

1001(

1

100

Price All Bonds

Pricing for un-traded or rarely traded bonds� 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 peer group

Pricing Methodology

Y

i

e

l

d

Real Transaction

Yield curve(AA)

Spread(AA)20bp

Evaluation Yield


Base yield curve

(AAA)

Spread of specific bond20bp

Evaluation Yield

15bp

15bp

In monitoring pricing performance, BWM provides feedback channels to encourage interaction with market participants. Key issues are announced to pricing customers and through website

Pricing Methodology

Daily ProcessBackground Study

Define Matrix

Segment Classes

Populate Info

Into Segments

Build Yield

Curves

Assign

Individual

Spread

Price All Bonds

Public AnnouncementPublic Announcement

�BWM shares the pricing process

Feedback ProcessFeedback Process

�� Officials verbal, web Officials verbal, web Internal Quality Internal Quality


and models with clients,

� BWM publishes its findings and studies (available through Web)

� Outcome of pricing disagreement resolution is shared with all customers.

�� Officials verbal, web Officials verbal, web and written channelsand written channels

�� Market interactionMarket interaction

Market and Customer Market and Customer

FeedbackFeedback

�� Customer can raise pricing queries at any time through any channel

Internal Quality Internal Quality

ControlControl

As part of our quality control, BWM regularly monitors its pricing performance through utilisingan internal monitoring system on a consistent basis

Pricing Methodology

Initial Pricing Performance : Marking to Model phase, Apr 2005 to July 2005


As part of our quality control, BWM regularly monitors its pricing performance through utilisingan internal monitoring system on a consistent basis

Pricing Methodology

Interim Pricing Performance : Marking to Market phase, Jan 2008 to Mar 2008

56.08%

40%

50%

60%

70%

80%

Probability (%)

Distribution MTM-Trade for Total Population 1-Jan-08 to 31-Mar-08


-20%

-10%

0%

10%

20%

30%

-90<=x<-80

-70<=x<-60

-50<=x<-40

-30<=x<-20

-10<=x<0

0<x<=10

20<x<=30

40<x<=50

60<x<=70

80<x<=90

Probability (%)

Spread Difference (bp)

Total Population (exclude outliers)

AGENDA









Bond Pricing, Current Practice and Pricing Issue

Sophisticated pricing methodologies are not used due to the lack of transparent data. Advanced pricing methodologies are still in primitive development.

Example: Pricing of option embedded bonds – current practice

P

I

II

I Interest

Payment

PPrinciple

Payment

P

I

II

Legal MaturityFirst Call Date

AIFf

Fc

Pn

−+

××

=∑

1

100'


� Current market practice is to price option embedded bonds to the first call� Cash flow after first call is discarded� Assumption is flawed� There are also no difference in pricing of American, European and Bermudan option

datecallfirstnwhere

AI

f

y

F

f

y

fP

DDnk D

Dk

=

−

×+

+

×+

=+−=

+−∑

'

)1

1001()

1

1001(

100

)21'(1)21(


Theoretical Method in Pricing of Bonds with Embedded Options

Example: Pricing of option embedded bonds – One Factor Hull & White Trinomial Tree

1) The price of option embedded bond can be computed by backwardation through an interest rate tree as follows:

P(T+1;mid)

P(T+1;dw)

P(T)

P(T+1;up)At time T, the non-exercise price can be computed by:

If the option is call and the exercise price at T is C, then the price of option bond at T can be determined as follows:

)](*);1(

)(*);1(

)(*);1([)exp()(

dwprobdwTP

midprobmidTP

upprobupTPtrTP exernon

++

++

+×∆×−=−


P(T+1;dw)P(T) = min [ C, ]

So, the price of option embedded bond is P(0).

)(TP exernon−

2) Hull and White suggested a two-stage method to generate the interest rate tree using the basic formula:

: the coefficient of long term mean

: mean speed: the volatility of short term interest rate

dzdtartdr σθ +−= ])([

)(tθ

a

σ



2) Hull and White suggested a two-stage method to generate the interest rate tree.

a) The first stage in building a tree for this model is to build a tree for a

variable that is initially zero following

the process .

*r

dzdtardr σ+−=**

A

E

3

2

26

1

222

222

tjaP

tajtjaP

m

u

∆−=

∆−∆+=

26

1

23

1

2

3

6

7

222

222

222

tajtjaP

tajtjaP

tajtjaP

d

m

u

∆−∆+=

∆+∆−−=

∆−∆+=Example: Pricing of option embedded bonds – One Factor Hull & White Trinomial Tree


Assumption: ,

First Stage Model:

Parameter Setting: , ,

: Minimum integer between and ,

Tree expansion: If the short-term interest reaches the two boundaries

or goes down , then the probabilities to up, middle, down ( ) will change.

0)( =tθ 0)0( =r

dzdtardr σ+−=**

tR ∆=∆ 3*σ tit ∆= RjR ∆=

*

maxjta∆

184.0

ta∆

816.0maxmin jj −=

maxjminj dmu PPP ,,

I

26

1222

tajtjaPd

∆+∆+=

2

3

6

7

23

1

26

1

222

222

222

tajtjaP

tajtjaP

tajtjaP

d

m

u

∆+∆+=

∆−∆−−=

∆+∆+=



2) Hull and White suggested a two-stage method to generate the interest rate tree.

b) The second stage in the tree construction is to convert the tree into a tree for r . This is accomplished by

displacing the nodes on the -tree so that the initial term structure is exactly matched. The approach is to

set the interest rates on r-tree at time to be equal to the corresponding interest rates on -tree plus

while keeping the probabilities the same. The procedure is to calculate s iteratively so that the initial

term structure is matched.

*r

*r

ti∆ *r

)( ti∆α α

Define �)()()( * trtrt −=α dttattd )]()([)( αθα −=

Example: Pricing of option embedded bonds – One Factor Hull & White Trinomial Tree


can be calculated as follows:

: Present value of security, which gives $1 at (i,j) node ( ), = initial -period interest rate,

given by term structure)

where : transition probability from node (i,k) to node (i+1,j) ( )

�

where P is the price computed from the current term structure of interest rate

α

jiQ , 10,0 =Q 0α t∆

∑ ∆∆+−=+

k

ikiji tRkjkpQQ ])(exp[),(,,1 α

),( jkpdmu PPP ,,

∑ ∆∆+−=+

j

ijii tRjQP ])(exp[,1 αt

PeQj

i

tRj

ji

i∆

−

=

∑ +

∆∆−

1, lnln

α

Bond Pricing, Current Practice and Pricing Issues - Islamic

Valuation method of Sukuks are indifferent to conventional bonds in market practice.

Fixed Payment Bond

Conventional

P

I

II

I Interest

Payment

PPrinciple

Payment

InterestAccrued

f

y

F

f

y

fF

c

PD

Dn

n

k DDk

−

×+

+

×+

××

=+−

=+−

∑)21(

1)21(

)1

1001()

1

1001(

1

100

Notation Descriptionsf Payment frequency in a yearc Cash flow rateF Face amount = Notional

Syariah principles conformed via product structuring Conventional valuation formula used

Fixed Payment Bond Formula


Islamic

F Face amount = Notionaly YieldD No. of days in one regular coupon periodD2 No. of days between the value date and the next payment daten Last payment periodP Clean Price

SN

SN

SN

PN

SN Secondary

Note

PNPrimary

Note

� Secondary Note in Islamic structure acts as the fixed profit payment as agreed in the contract.

� Cash flow rate in Islamic structure derived as the ratio between the secondary note amount and the primary note amount

� Primary amount is the face amount

� Inclusion of asset volatility

� Term structure of asset

� Floating rate mechanism for the forward rate


Islamic and conventional bonds are fundamentally different in both structure and thus valuation

Islamic Bond Differences from Conventional Bonds

� Not an exchange of paper or money but an exchange of Syariah approved assets

� In principle, Islamic bond structure is similar to asset securitisation

� Differing market perception resulting in differentiated trading behaviour – liquidity, risk premium, etc.

� No imposition of interest but uses secondary notes as profit

Many more unaccounted Islamic features in current

market valuation


� Floating rate mechanism for the forward rate agreement in the unconditional and irrevocable purchase of asset at maturity

� Prepayment risk modeling

� Counterparty risk modeling

� No imposition of interest but uses secondary notes as profit payments

� Profit earned through financial consideration for the exchange by applying Syariah principles

� Additional risks that are uncommon in conventional bonds such as religious and regulatory risks

Rather than relying on the performance of the underlying assets, Islamic bonds are currently

priced as per their conventional counterparts and almost arbitrarily.


Example – KL Sentral Sdn Bhd (KLSSB) Musyarakah Venture with Kuwait Finance House (KFH) as option writer

Investors

Trustee

KLSSBKLSSB

� Trustee overseeing the Musyarakah

KFH

51

Proceeds from PU for Sukukredemption and profit payments

� Musyarakah

KLSSB issues Sukuk and receives

proceeds in return Cashflow payments in arrears via

aggregated project revenue

Unconditional and irrevocable purchase of assets

Market prices KLSSB as a fixed payment bond to legal maturity disregarding asset issues.

Bond has pricing issue on asset pricing

� Forward pricing of assets require a forward rate


KLSSBKLSSB (as Wakeel to Investors)

4

Purchase Undertaking (PU)

KFH

� Put Option terms and conditions

Put Option

Musyarakah Venture to sell

Project Lands

23

Stake of Musyarakahpartners based on their capital contribution of 74:26 from KLSSB (in kind) and Sukukholders (cash)

� Musyarakahpartners appoint KLSSB as the Project Agent

Distributable profit to be shared semi-annually

based on an agreed profit sharing ration of 99%:1% to KLSSB and Sukukholders

IH

IL

IHH

IHL

ILH

ILL

I0

Bond has pricing issue on asset’s embedded option

� Forward pricing of assets require a forward rate benchmark of asset class

� Consideration must be taken for counterparty risk at the end of the contract

….

� Asset volatility and term structure of asset class. Eg equity industry index volatility

� Asset data greatly needed� Optionality of the put/call feature


In asset pricing, many considerations must be taken in the cash flow structure and risk exposure

Cash Flow

Sale

DeliveryPrice Payment

Lease

DeliveryPrice Payment

Equity

PaymentPrice

� Discount

� Negotiated

� Mark up

� Immediate

� Deferred

� End of Period

� Advance

� Staggered

� End of Period

� Discount

� Negotiated

� Mark up

� Immediate

� Deferred

� End of Period

� Advance

� Staggered

� End of Period

� Discount

� Negotiated

� Mark up

� Advance

� Staggered

� End of Period


Risk Exposure to Asset

Asset

UsufructProperty

� Fixed

� Floating

� Fixed

� Floating

Entity

� On Issuer

� On theBusiness

�Breakdown necessary to avoid mismatch in the Islamic bond’s risk consideration

�Sukuk contract is the cosmetic of the asset

�Key challenge is on data aggregation on

specific asset classes and using these

information in pricing models

Pricing Methodology


FAQ

FAQ

1. Why is BWM’s price is different from next day’s actual traded price?� BWM publishes end of day price, not next day’s price forecast.

2. Does BWM publish Credit Opinions?� No. BWM is not a Credit Rating Agency.

3. Does BWM announce future price opinions?� No, BWM is market neutral. BWM does not provide its opinion on future price direction.

4. Should pricing in NAV accounting be the same with BWM’s prices?� Not necessarily. BWM’s prices are based on is own opinion. Each portfolio manager


� Not necessarily. BWM’s prices are based on is own opinion. Each portfolio manager should assess BWM’s prices and use their own judgment in applying the prices.

5. Does BWM listen to pricing opinions from clients?� Yes. BWM is always eager to get customer’s feed-back and different pricing

opinions. If BWM decides to re-adjust its valuation after a feed-back, the result will be shared with all customers.

THANK YOU

Meor Amri bin Meor Ayob

[email protected]


19-5 , The Boulevard, Mid Valley City, Lingkaran Syed Putra, 59200 Kuala Lumpur, MalaysiaTel: +603 2711 5122 Fax: +603 2284 1807 Email : [email protected]

[email protected]

Pricing Specialists

Simon NgTan Keang ChuanPaige TanNuraizah HarunNoor Bazlina SharifmuddinWong Yin Yee

Financial Engineer

Ken PohDarryl Foo

Email Address

[email protected]

General Line

+603 2711 5125


Documents

What is a Bond Pricing Agency