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

Unchanged Value of Assets

Market change is not reflected

Deterioration of customers’ trust

Obstruction of market efficiency

Unchanged Value of Assets

Market change is not reflected

Deterioration of customers’ trust

Obstruction of market efficiency

Book Value ApproachBook Value Approach

Raise of market transparency, fairness and efficiency

Market change is reflected immediately

Compliance with higher risk management, compliance, reporting and audit requirements

Raise of market transparency, fairness and efficiency

Market change is reflected immediately

Compliance with higher risk management, compliance, reporting and audit requirements

Mark-To-Market ApproachMark-To-Market Approach

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 marketIncreasing 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.

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 marketIncreasing 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.

The Need for Bond PricingThe Need for Bond Pricing

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 evalua

tion methodology. This methodology is transparent and consistent.

2.0 Benefits of Bond Pricing for the Bond Market

Revitalizing the Primary 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 Secondary 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.

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.

2.0 Benefits of Bond Pricing for the Bond Market

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

Improving Soundness of Financial Institutions

2.0 Benefits of Bond Pricing for the Bond Market

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

3.1 Pricing Process

Market study

Bond Structure Number of Issues Key Data Challenges

Fixed Rate Bond

95% of Data

Term Sheet Vs Actual BIDS Data

Zero Coupon Bond Term Sheet Vs Actual BIDS Data

Fixed Regular Amortizing Bond Less than 10 Term Sheet Vs Actual BIDS Data

Irregular Amortizing Bond Mostly ABS Less than 20 StocksIrregular amount may change over time and not static, Pool Information

Callable Amortizing Bond Less Than 10 stocks Term Sheet Vs Actual BIDS Data

Callable Multi Step Amortizing Less Than 10 stocks Term Sheet Vs Actual BIDS Data

Multi Step Amortizing Bond Less Than 10 stocks Term Sheet Vs Actual BIDS Data

Multi Step Bond 25 Stocks Term Sheet Vs Actual BIDS Data

Callable Multi Step Popular Structure Less than 50 Stock Term Sheet Vs Actual BIDS Data

Floating Rate Note Less than 10 issues Index Data/Time Series of Banks BLR Rate

Flipper / (Fixed , Float Structure) 2 Issues Only Long Term Index of MGS 5Year

Callable/Put table Bond Less than 15 stocksIssues on Strike Price determination based on a formula, Credit Related Trigger

Convertible Bond4 Only which meets BWM Pricing Criteria of Convertible to Listed Equity

Stock Price Data/Historical Volatility, Strike Price Based On Formula

Callable Convertible 5 Stocks OnlyStock Price Data/Historical Volatility, Strike Price Based On Formula, Credit Event Trigger

Multi- Step Callable Convertible 3 Stock Only Stock Price Data/Historical Volatility

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

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

Coupon Rate

TMT 1

TMT 2

6.25% for 15 Y

5.25 % for Year 1 to 5, MGS5Y +120BP for Year 6 to 10

& MGS5Y + 120BP for Year 11 to 15

Call TMT 2 At Par by Issuer on Year 5 or Year 10

Put TMT 2 If Rating < AAA on Year 5 or Year 10 Against Telekom

3.2 Pricing Process

Information Maturity

Market

Maturity

Market Maturity

Liquid Secondary Market

Large Pool of Market Participants

Supply of Secondary Trading Instrument

Informational Maturity

Contents of the Information

Access to the Information

Structured Approach

Risk Neutral Approach

Hybrid Approach

Hybrid Approach

Adopting the right pricing strategy corresponding to the unique environment of the Malaysian market is critical

Bond Pricing Approach

3.2 Pricing Process

Bond Price = f (Risk Free Interest Rate+ Credit Spread)

Derived via Structural Model

Risk Neutral ModelJarrow-Turnball type model

Merton type model

2. Derivation of Credit Spread for PDS

1. Derivation of Risk Free Curve

Zero Coupon

Yield

Maturity

ObservedTrades

BootstrapCalibration

3.3 Pricing Process

Risk Neutral (Reduced Form) Model : Jarrow Type Credit Model

Prices

Risk Free Yield Curve

Calibration

Recovery Value

Credit Spread

Market Price is assumed to reflect the true value of the Bond.

Recovery Value is normally extracted from the disclosure of Rating Agency.

Apply to Bond Pricing

3.4 Pricing Process

Credit Spread

Measuring the Probability of

Default

Company Value

Liabilities

Stability

Measuring the Recovery Value

Rating Agency Disclosure

Statistical Analysis

Structural Model : Merton Type Model

Apply to Bond

Pricing

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)

3.6 Pricing Process

Derivation of individual spread for PDS via:•Application of credit score•Structure•Size•Observation from past trades•Market and macro Economic factors

Price ALL bonds

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

Define Matrix

Segmentation Classes

Populate intosegments

Build yield curves

Assign IndividualSpreads

Background Study Daily Process

Any trading data

RISK NEUTRAL MODEL

ELEMENT

STRUCTURAL MODEL ELEMENT

Other studies:Credit scoring of issuers within

industry

Apply filtration andwatch bond rules

Feedback and Verification with

market

3.7 Pricing Process

Yield

Term to Maturity

Real Transaction

Base yield curve(AAA)

Yield curve(AA)

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

Pricing of bonds that are untraded or rarely traded

Spread(AA)

20bp

Spread of specific bond20bp

Evaluation Yield

15bp

15bp

Evaluation Date

3.8 Pricing Process

Callable Amortizing Bonds with Secondary NotesDiscount BondBullet BondFixed Rate BondAmortizing BondCallable BondConvertible BondExchange BondBond with WarrantsFixed Rate ABSCallable ABSFixed Rate MBSCallable MBSStepping FRBFloating Rate NoteFloating Amortizing NoteFloating Rate ABSFloating Rate MBSBond with Secondary NotesAmortizing Bond with Secondary NotesCallable Amortizing BondStepping Amortizing BondCallable Stepping BondCallable Stepping Amortizing BondConvertible Stepping BondCallable Bond with Secondary NotesConvertible Bond with Secondary Notes

Bond types priced by BWM:

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

4.0 Delivery Channels

BWM Daily Valuations

5 pm KL

BONDSTREAM

PRICING

TERMINAL

WEB

DOWNLOAD

DIRECT DATA

FEED

3 different delivery modes to suit client’s requirements

Excel download

csv file download

File to file transfer direct into

client’s system

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