What Is A Bond Pricing Agency

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

now and across the horizon
RAM Economic Series June 2008

20 June 2008
Meor Amri bin Meor Ayob
©Copyright BONDWEB MALAYSIA SDN.BHD. - All rights reserved.

Fundamentals of the Market
The Full Circular Flow
Goods and services
Buyer And Seller

Money
Medium Of Exchange
PRICE
Resources (Input)
Production and People

Distribution (Consumers)
Goods and Services

(Output)
Money

AGENDA
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
What Is A Bond Pricing Agency
Introducing Bondweb Malaysia Sdn Bhd
Pricing Methodology
Bond Pricing, Current Practice and Pricing Issues

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
96% y-o-y
growth in Binariang GSM’s Senior Islamic bond
Islamic
PDS issuance worth RM20 billion is the
largest corporate bond issue in Malaysia
yet
* 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

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 Convertible Bonds with Secondary Notes

Bullet Bonds Callable Amortizing Bonds with Secondary Notes
Fixed Rate Bonds Stepping Amortizing Bonds with Secondary Notes
Amortizing Bonds Callable Discount Bond
Callable Bonds Callable Convertible Discount Bond
Convertible Bonds Callable Stepping Bonds with Secondary Notes
Exchange Bonds Exchangeable Stepping Bonds
Bond with Warrants
Fixed Rate ABS
Callable ABS As of June 2008
Fixed Rate MBS
Callable MBS Total stocks in the market: 2717
Stepping FRB 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 Bithaman Ajil
Al Qardhul Hasan
Bai' Bi Al-Taqsit
Bai Dayn
Bai Dayn & Murabahah
Bai-Al-Einah
Ijarah
Istisna
Mudharabah
Murabahah
Musyarakah
Combinations include:
Al Bai Bithaman Ajil & Bai Einah
Mudharabah & Murabahah
Murabahah & Bai Al Dayn
Murabahah & Musyarakah
Murabahah & Ijarah
Istisna & Mudharabah

AGENDA
Pricing Methodology

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
Problem The BPA evaluates about 2,000+ bonds that

Less than 1% are traded, where are the are not traded on any given day, based on
prices for the remaining 99%? the market prices
The BPA needs to employ reliable database

The Need and evaluation methodology. This
Daily valuation of bond portfolios for NAV methodology MUST be transparent and
calculation and portfolio valuation consistent
Increase Increase
Current method Transparency Liquidity
Quotes from brokers or banks, a few via
internally generated models – bias?
BPA
Managing & Compliance &

Monitoring Risk Audit

LAST TRADE LAST TRADE

BOND NAME VALUE DATE MTM PRICE MTM YIELD PRICE 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
SMC 7/2003 11.04.2008 22-Feb-08 100 3.43 99.98 3.53 31-May-07
©CopyrightBONDWEB
©Copyright BONDWEB MALAYSIA
MALAYSIA SDN.BHD.
SDN.BHD. - Allreserved.
- All rights rights reserved.
BPAs are new entities and currently only three countries use the BPA framework
Korea
Thailand
Mexico Egypt (in development)
Malaysia
Indonesia (in development)
Mexico Malaysia Thailand Korea

Two price vendors under Bondweb Malaysia Sdn Bhd Thai Bond Market Association (SRO) Korea Bond Pricing
the purview of Banco De KIS Pricing, Inc
Mexico NICE Pricing Services, Inc

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 BPA valuation approved by the SC may revitalize the bond market using mark-to-market
Secondary prices as benchmark by publicly announcing them
Market for Bonds Marking-to-market system provide strategy alternatives to traditional hold-to-maturity
strategies.
From an origination and underwriting perspective, primary level pricing becomes

Revitalizing the
challenging especially for lower credits
Primary Market
Mark-to-market pricing on previously issued corporate bonds can promote new corporate
for Bonds
bond issues by functioning as benchmarks for primary level pricing
Promoting New BPA’s transparency in the methodologies being used will spur the evolution of the bond
Product market with further advance pricing methodologies
Development 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 Providing price discovery may assist in financial institutions' compliance to international
Soundness of standards such as IAS 39 and Basel 2 requirements.
Financial Effectiveness of risk management will be further enhanced as the valuation process will be
Institutions consistent and not arbitrary

AGENDA
Pricing Methodology

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 Pricing
Agencies
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 available
source.
Help facilitate finer price discovery hence spurring trading activity that enhances risk management and
optimises capital allocation
Bondweb user demographics includes Banks, Unit Trust and Asset Managers, Insurers, Government
Agencies and Corporations

Vision and mission of Bondweb Malaysia Sdn Bhd
To create an open and low cost bond market

information exchange platform accessible to all
market players and optimised to local needs
To provide a consistent and systematic bond fair

valuation infrastructure currently lacking in the
Malaysian fixed income market
To provide a forum and platform for all market

participants on market issues and news
To participate with the market in enhancing the

standards of pricing, trading and structuring fixed
income 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

2001 Began groundwork in Malaysia information services between:
Discussions with SC and BNM
-
Market study and research Rating Agency Malaysia Consultancy Sdn Bhd
2004 Mainstream and Co., Ltd (Korea)
Sept: Bondweb Malaysia Sdn Bhd
Lembaga Tabung Angkatan Tentera (LTAT)
established UTIX Sdn Bhd (Usaha Tegas)
2004 PacificMas Berhad
March: BWM website launched Malaysian Trustees Berhad
July: Bondstream pilot launch
2005
Sept: Full marked-to-market process With participation from:
Oct: Commercial deployment of MARC on data and technical support
Bondstream SC and BNM in observer and advisory role
Market community (buy/sell side, brokers) via
April 18: Appointed Malaysia’s first Bond “Bottom Up” approach
Pricing Agency
2006
Adhered to strict SC requirements to qualify as BPA:
January 3 : Guidance Note 15 on Mandatory Audited methodology and process
use of BPA prices by unit trust
2007 companies Three months market acceptance test
RM10 million minimum paid up capital and professional
indemnity insurance
No controlling shareholders
Status as at June2008:
> 70 clients (banks, AMC, UTMC, insurance
companies, corporate, quasi governments)


BWM’s Pricing Services
3 different delivery modes to suit clients’ requirements 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
BondStream
Pricing Terminal consistent and market neutral valuations
The bond pricing process is transparent and uses
Excel download global standard pricing models
The models are customised to meet the unique needs
of the Malaysian market
BWM Daily
Valuations BWM prices unlisted MYR bonds (Conventional and
6 pm KL Islamic). For now we do not price short term papers,
unrated bonds, loan stocks and listed bonds
Direct Data Feed Web Download We incorporate a market feedback mechanism in the
event where there are disputes or queries on the
prices
File to file transfer CSV file download
direct into client’s
Intimate local knowledge of the instruments and
system market structure is vital to ensure credibility of the
BPA

Product Lines
Optimised to the needs of market participants
1) Fair Valuation
- Daily MTM prices/yields
Launched in
2) Bond Information
2005
- Primary Market Data
- Secondary Market Data
3) Reference Pricing Service
4) Bond Index
Launched in
5) Basel II Support Pack 2008
6) RBC Support Pack
7) Customized Data Delivery

Delivery Channels – bond information portal at www.bondweb.com.my
News and Research Secondary Market

Market News Daily Trading
Market Research from Trade Statistics
local and international Trading Charts
research houses Historical Data
Community Yield Analysis

Market Opinion Yield Matrix
Market Commentary Yield Curve
Primary Market Other Market Information

Facility Information Money Market
Stock Information Equity Market
Issuer Financial FX market
Information
Credit Rating Information
Issue Statistics
Tender Information

Delivery Channels – custom designed software tool BondStream
Bond Database Analysis Tools

Stock Info Bond Analysis Tools
Facility Info Bond Calculator
Rating Info W.I Simulator
Bond Statistics Favourite bonds
Statistics database Bond Advanced Search
Corporate info database Bond Trade search
Islamic bond data Custom Report generator
Trading data Charting

Real-time Quotes Real-time quote charts
Daily trading activity Daily charts
Historical trades back to Yield curves
2000 Technical analysis tools
Trade map
Market depth
Fair Valuation Market Data

Daily MTM prices for MYR Indicative Money Market
unlisted bonds rates
YTM matrices on Research and
Conventional and Islamic commentaries
bonds Real time news

AGENDA
Pricing Methodology

Pricing Methodology
Bond Pricing Approach – Current Industry Practice and the Assumptions
Four common market practices are used in conducting bond pricing. BWM employs
the hybrid approach
YTM Matrix /
Curve Pricing
Approach Type Pricing Method Granularity
YTM Matrix / Curve Quote Driven Curve Pricing
Pricing
Individual
Quotation Individual Quotation Quote Driven Individual Bond
Approach
Approach
Model Approach Theoretical Individual Bond
Model Approach Hybrid Approach Hybrid Individual Bond

(Mark To Model)
Hybrid Approach

Pricing Methodology
1y 2y 3y …
YTM Matrix / Quoted Bonds
AAA 3 4 5 …
Curve Pricing
AA 3.5 4.5 … … Marking to
market
A … … … …
BBB … … … …
Individual
Quotation
Approach
Assumptions:
1.Market Liquidity/Efficiency
Contributed Quotations are assumed to be an unbiased
Model Approach market representation.
(Mark To Model) Market is liquid without seasonal effects.
2.Homogeniety
Bonds belonging to the same segment are assumed
identical.
Hybrid Approach

Pricing Methodology
YTM Matrix / Quoted Bonds Traded Bonds

Curve Pricing M M
a a Marking to
p p market
Individual
Quotation
Approach
Assumptions:
1.Market Liquidity Efficiency
Contributed Quotations are assumed to be an unbiased
Model Approach market representation.
(Mark To Model) 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.
Hybrid Approach

Pricing Methodology
A A
YTM Matrix / Financial Data n n
Interest Rate Data a Liquidity Model a
Curve Pricing Asset Value l l
Credit Scoring Model
Asset Volatility y Term Structure Model y Marking to
Recover Rate t t market
Risk Free Rate i i
Curve Rate c c
Individual s s
Quotation
Approch
Assumptions:
1.Model Is Winner
Mathematical model generates price
Model Approach Underlying information is accurate and timely
(Mark To Model)
Hybrid Approach

Pricing Methodology
YTM Matrix /
Curve Pricing
Individual
Quotation
Approch
Model Approach
(Mark To Model)
Hybrid Approach
(BWM’s
Approach) Back-test representation of market value by marking to model shows
inaccuracies with actual market trades
Market is winner not model

Pricing Methodology
Quoted Bonds
YTM Matrix /
Curve Pricing Calibrating
Implied Marking to
Risk Premium
From Market market
Pre and Data
Traded Bonds Post Data
Pool
Individual
Quotation
Approch
Assumptions:
1. Market Liquidity/Efficiency
Credit risk model
Market is not liquid, trade frequency is low. Still, trade
Liquidity risk model prices (if properly monitored) can provide information for
Model Approach
(Mark To Model) Term structure model 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
Hybrid Approach of Contributors monitor individual bond value on an on-
going basis.

Pricing Methodology
BWM’s Pricing Methodology – An Overview
Bond Price = f ( Benchmark Rates + Credit Spread )
Y Derivation of benchmark rate

i
e Risk
Liquidity
l Credit Risk
d Risk
Term to Maturity
Segmentation Cube
Quotations
Individual Bonds
Measuring the
Market Price
Trades Of Risk
Individual Bond
Valuation

Pricing Methodology
A daily process is conducted to price all bonds
Background Study Daily Process
Assign
Define Matrix Populate Info Build Yield
Individual Price All Bonds
Segment Classes Into Segments Curves
Spread
Segmentation Apply filtering and Derivation of Feedback and

Analysis watch list rules individual Verification with
spread for PDS via: market
Application of
credit score
Any trading data Structure
Industry
Trade Data Observation from
Aggregation past
trades
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.

Pricing Methodology
Define Matrix Segment Classes
Data is segmented into classes and ranked according to its credit quality and liquidity performance
Macro Segmentation Micro Segmentation
Evaluating Risk at
Individual Bond Level
Issuer Ranking
Individual Bonds
Credit Rating/Issuer Type
Industry Ranking bonds based on credit analysis
Product Structure and scoring
Characteristic Accounting-based Models (Altman’s type)
Liquidity 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 BWM Internal Process Data Population
Macro Segment
Term Sheet, FAST Term sheet
Enhancement
ETP Ratings
Model
Selection
Market Network
Trade Data
Term Sheet, Pricing Enhancement
Validation Convention
Broker
Swap Yields Micro Segment
Quotes

Pricing Methodology
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
Data Filtering will identify trades and quotes that are not representative of current market levels
Issues
Y
Outliers from I
normal trade band E
L
D
Solution
Filtering Rule
Out of Credit Rule

Liquidity Rule
Assignment of Confidence
Interval
Relative Movement against
General Market Direction
Term to
Maturity

Pricing Methodology
Build Yield Curves
Using the filtered data, calibrate risk free and credit curves for MGS and PDS
Calibrating Risk Free Curve from MGS
Bootstrap
Calibration
MGS Data
Zero Coupon Maturity
Yield
Calibrating Credit Curve for PDS
PDS Data
Calibrating Risk Premium by Credit
each Segment Curves Maturity

Pricing Methodology
Government Bond Pricing
Generation
Gather Required First Validation
of Spot Yield
Info Filtering of Result
Curve
Market Info
Y
Post-trade info from ETP
i
e Pre-trade info money brokers
l Pre-trade info bank contributions
d
Term to Maturity

Pricing Methodology
Generation
Gather Required Validation
First Filtering of Spot Yield
Info of Result
Curve
Exclude Unusual Trades

Y
Cross Trades
i
e Odd Lots
l Off Market
d Position Parking
Exclude Outliers
Compared to historical trades and quotes
Compared to past evaluated yield
Term to Maturity

Pricing Methodology
Generation of
Gather Required First Validation
Spot Yield
Info Filtering of Result
Curve
Generate YTM Curve

Y
Zero curve is not directly observable from
i
the market
e
l
d 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
Term to Maturity

Pricing Methodology
Generation
Gather Required First Validation of
of Spot Yield
Info Filtering Result
Curve
Loop Back Test

Y
Calibrate YTM / Zero curve to ensure MTM
i
values are market relevant
e
l
d
Term to Maturity

Pricing Methodology
PDS Credit Curve
Credit
Data Population First Spread
Validation
Into Segment Filtering Curve
Generation
Market Info
Y
OTC trading
i
e Money brokers
l
d
Segmentation Cube
Term to Maturity

Pricing Methodology
PDS Credit Curve
Generation
Data Population Validation
First Filtering of Spot Yield
Into Segment of Result
Curve
Exclude Unusual Trades

Y
Cross Trades
i
e Odd Lots
l Off Market
d Position Parking
Exclude Outliers
Compared to historical trades and quotes
Compared to past evaluated yield
Out of credit rule
Term to Maturity

Pricing Methodology
PDS Credit Curve
Credit Spread
Data Population First
Curve Validation
Into Segment Filtering
Generation
Credit Curve
Y
Derive from trade prices in segment
i
e Risk free yield from MGS curve
l
d Credit Spread Rule
Spread along the maturity
Spread by size of risk
Risk Free Yield
Term to Maturity

Pricing Methodology
Assign Individual Spread
Now that the curves are ready, assign individual spread that reflects the bond’s appropriate risk according to the result
from the ranking model
Bond A
Y Credit risk spread 2 Credit class Y
I 2i from risk free curves I Bond B
Bond C
E E Bond D
L L Bond E
D D
1 Risk free interest
rate curve
Tenor t
Term to Maturity Term to Maturity
Bond Price Curve YTM at Tenor t
= f (Risk Free Interest Rate , Risk Spread)

Bond Bond Bond Bond Bond
Risk Spread E D C B A
Negative Positive
= f (Credit, Individual) Spread Spread

Pricing Methodology
Price All Bonds
Apply relevant bond type price formula Notation Descriptions

f Coupon payment frequency in a year
Eg1 : Fixed coupon bonds with regular period c Coupon rate
c 1 F Face amount = Notional
n
×F× y Yield *
100 f F AI Accrued Interest
∑ y 1 ( k −1+ D 2 )
+
y 1 ( n −1+ D 2 )
− AI
D No. of days in one regular coupon
k =1
(1 + × ) D
(1 + × ) D
period
100 f 100 f
D2 No. of days between the value date and
the next coupon Date
Eg2 : Fixed coupon bonds with short first coupon n Last coupon period
E/U No. of days between the pseudo issue /
c 1 FIF c 1 real last coupon date and the real first
×F× × ×F×
100 f E n
100 f F coupon / pseudo maturity date (short
+∑ + − AI first / last coupon)
y 1 D 2 y 1 ( k −1+ E )
D 2 y 1 ( n −1+ D 2 E )
(1 + × ) E k =2
(1 + × ) (1 + × )
100 f 100 f 100 f No. of days between the pseudo issue /
pseudo last coupon date and the
pseudo first coupon / pseudo maturity
Eg3 : Fixed coupon bonds long first coupon date (long first coupon)
c 1 c 1 LIF FIF / LIF No. of days between the real issue date
n−1
×F× ×F× × / real last coupon and the real first
100 f 100 f U F
∑
k =1 (1 +
y 1 (k −1+ D)
D 2
+ LIF D 2
y 1 (n−1+ U + U )
+ LIF
y 1 (n−1+ U + D2U )
− AI coupon / real maturity date
(Short First / Last Coupon Bond)
× ) (1+ × ) (1 + × )
100 f 100 f 100 f
No. of days between the real issue /
pseudo last coupon date and the
* Price computed using yield derived from the pseudo first coupon / real maturity date
(credit spot rate at discount period t + individual spread) (Long First / Last Coupon Bond)

Pricing Methodology
Price All Bonds
Apply relevant bond type price formula Notation Descriptions

f Coupon payment frequency in a year
Eg4 : Stepping Bonds c Coupon rate
F Face amount = Notional
ck 1
n
×F× y Yield *
100 f F AI Accrued Interest
∑ y 1 ( k −1+ D )
D 2
+
y 1 ( n−1+ D 2 D )
− AI
D No. of days in one regular coupon
k =1
(1 + × ) (1 + × ) period
100 f 100 f
D2 No. of days between the value date and
the next coupon Date
Eg5 : Amortizing Bonds n Last coupon period
RPi Remaining principal at future time ti
−
c 1 Current/forward coupon rate following
× RPk × Index t
n convention
100 f RPn
∑ y 1 ( k −1+ D )
D 2
+
y 1 ( n −1+ D 2 D )
− AI
k =1
(1 + × ) (1 + × )
100 f 100 f
Eg6 : FRN _
c 1 I ndext 1
×F× n
×F×
100 f 100 f F
+∑ + − AI
y 1 ( D) k =2
D 2 y 1 (k −1+ D)
D 2 y 1 (n−1+D2 D)
(1+ × ) (1+ × ) (1 + × )
100 f 100 f 100 f
* Price computed using yield derived from the

(credit spot rate at discount period t + individual spread)

Pricing Methodology
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 Y
Estimate the spread of the bond relative to i
changes in the yield curves and other peer group
e
l
d Yield curve(AA)
20bp Spread(AA)
Evaluation Yield Real Transaction
20bp Spread of specific bond

15bp
Base yield curve
(AAA)
15bp

Pricing Methodology
In monitoring pricing performance, BWM provides feedback channels to encourage interaction
with market participants. Key issues are announced to pricing customers and through website
Background Study Daily Process
Assign
Define Matrix Populate Info Build Yield
Individual Price All Bonds
Segment Classes Into Segments Curves
Spread
Feedback Process Public Announcement

Officials verbal, web BWM shares the pricing process
Internal Quality and models with clients,
and written channels
Control
Market interaction
BWM publishes its findings and
studies (available through Web)
Outcome of pricing
Market and Customer disagreement resolution is
Feedback shared with all customers.
Customer can raise
pricing queries at any
time through any channel

Pricing Methodology
As part of our quality control, BWM regularly monitors its pricing performance through utilising
an internal monitoring system on a consistent basis
Initial Pricing Performance : Marking to Model phase, Apr 2005 to July 2005

Pricing Methodology
As part of our quality control, BWM regularly monitors its pricing performance through utilising
an internal monitoring system on a consistent basis
Interim Pricing Performance : Marking to Market phase, Jan 2008 to Mar 2008
Distribution MTM-Trade for Total Population 1-Jan-08 to 31-Mar-08

80%
70%
60% 56.08%
50%
Probability (%)
40%
30%
20%
10%
0%
-10<=x<0
0<x<=10
20<x<=30
40<x<=50
60<x<=70
80<x<=90
-90<=x<-80
-70<=x<-60
-50<=x<-40
-30<=x<-20
-10%
-20%
Total Population (exclude outliers)
Spread Difference (bp)

AGENDA
Pricing Methodology

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
I I I Interest
Payment
P P Principle
P
I I I I Payment
First Call Date Legal Maturity

c 1
n'
×F×
100 f F
P=∑ + − AI
y 1 ( k −1+ D 2 D ) y 1 ( n ' −1+ D 2 )
k =1
(1 + × ) (1 + × ) D
100 f 100 f
where n' = first call date
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

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:
At time T, the non-exercise price can be computed by:

P(T+1;up)
Pnon−exer (T ) = exp(−r × ∆t ) × [ P(T + 1; up) * prob(up)
+ P(T + 1; mid ) * prob(mid )
+ P(T + 1; dw) * prob(dw)]
P(T) P(T+1;mid)
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:
P(T+1;dw)
P(T) = min [ C, Pnon−exer (T ) ]
So, the price of option embedded bond is P(0).
2) Hull and White suggested a two-stage method to generate the interest rate tree using the basic formula:
dr = [θ (t ) − ar ]dt + σdz
θ (t ) : the coefficient of long term mean
a : mean speed
σ : the volatility of short term interest rate

7 a 2 j 2 ∆t 2 − 3aj∆t
Example: Pricing of option embedded bonds – One Factor Hull & White Trinomial Tree Pu = +
6 2
1
Pm = − − a j ∆t 2 + 2aj∆t
2 2
2) Hull and White suggested a two-stage method to generate the interest rate tree. 3
E 1 a 2 j 2 ∆t 2 − aj∆t
a) The first stage in building a tree for this model is to build a tree for a Pd = +
6 2
variable r * that is initially zero following
the process dr * = − ar * dt + σdz .
1 a 2 j 2 ∆t 2 − aj∆t
Pu = +
6 2
2 A
Pm = − a 2 j 2 ∆t 2
3
1 a 2 j 2 ∆t 2 + aj∆t
Pd = +
6 2
Assumption: θ (t ) = 0, r (0) = 0
* *
First Stage Model: dr = − ar dt + σdz 2 2 2
I P = 1 + a j ∆t + aj∆t
u
* 6 2
Parameter Setting: ∆R = σ 3∆t , t = i∆t , R = j∆R
*
1
0.184 0.816 Pm = − − a 2 j 2 ∆t 2 − 2aj∆t
j max : Minimum integer between j = − j 3
and a∆t , min max
a∆t 7 a 2 j 2 ∆t 2 + 3aj∆t
Pd = +
Tree expansion: If the short-term interest reaches the two boundaries 6 2
j max or goes down j , then the probabilities to up, middle, down ( Pu , Pm , Pd ) will change.
min

Example: Pricing of option embedded bonds – One Factor Hull & White Trinomial Tree
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 r into a tree for r . This is accomplished by
*
displacing the nodes on the r-tree so that the initial term structure is exactly matched. The approach is to
set the interest rates on r-tree at time i∆t to be equal to the corresponding interest rates on r * -tree plus
α (i∆t ) while keeping the probabilities the same. The procedure is to calculate αs iteratively so that the initial
term structure is matched.
*
Define α (t ) = r (t ) − r (t ) dα (t ) = [θ (t ) − aα (t )]dt
α can be calculated as follows:
Qi , j : Present value of security, which gives $1 at (i,j) node ( Q0, 0 = 1 ), α 0 = initial ∆t -period interest rate,
given by term structure)
Qi +1, j = ∑ Qi , k p(k , j ) exp[−(α i + k∆R)∆t ]
k
where p ( k , j ) : transition probability from node (i,k) to node (i+1,j) ( Pu , Pm , Pd )
ln ∑ Qi , j e − j∆R∆t − ln Pi +1
j
Pi +1 = ∑ Qi , j exp[−(α i + j∆R )∆t ] α i =
j ∆t
where P is the price computed from the current term structure of interest rate

Bond Pricing, Current Practice and Pricing Issues - Islamic
Valuation method of Sukuks are indifferent to conventional bonds in market practice.
Syariah principles conformed via product structuring Conventional valuation formula used
Fixed Payment Bond Fixed Payment Bond Formula

Conventional c 1
n
×F×
100 f F
I I Interest P=∑ + − Accrued Interest
k =1 (1 +
y 1 ( k −1+ D )
D 2 y 1 ( n−1+ D 2 D )
Payment × ) (1 + × )
100 f 100 f
P Principle
P
I I Payment
Notation Descriptions
f Payment frequency in a year
c Cash flow rate
F Face amount = Notional
Islamic y Yield
D No. of days in one regular coupon period
SN D2 No. of days between the value date and the next payment date
n Last payment period
P Clean Price
SN
Secondary Note in Islamic structure acts as the fixed profit payment as
SN agreed in the contract.
SN Secondary
Note Cash flow rate in Islamic structure derived as the ratio between the
secondary note amount and the primary note amount
PN Primary
PN Note
Primary amount is the face amount

Islamic and conventional bonds are fundamentally different in both structure and thus
valuation
Islamic Bond Differences from Conventional Bonds Many more unaccounted
Islamic features in current
Not an exchange of paper or money but an exchange of market valuation
Syariah approved assets
In principle, Islamic bond structure is similar to asset

securitisation
Inclusion of asset volatility
Differing market perception resulting in differentiated trading
Term structure of asset
behaviour – liquidity, risk premium, etc.
Floating rate mechanism for the forward rate
No imposition of interest but uses secondary notes as profit
agreement in the unconditional and
payments
irrevocable purchase of asset at maturity
Profit earned through financial consideration for the
Prepayment risk modeling
exchange by applying Syariah principles
Counterparty risk modeling
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
Market prices KLSSB as a fixed
Investors payment bond to legal maturity
disregarding asset issues.
KLSSB issues Proceeds

Trustee Trustee
Sukuk and from PU for
overseeing the
receives Sukuk
proceeds in
1 5 redemption
Musyarakah Bond has pricing issue on asset pricing
return and profit Cashflow payments in arrears via
payments aggregated project revenue
Unconditional and irrevocable

purchase of assets
Musyarakah
partners KLSSB KLSSB Put KFH Forward pricing of assets require a forward rate
appoint (as Wakeel to Investors) Option benchmark of asset class
KLSSB as the Consideration must be taken for counterparty risk at the
Project Agent Put end of the contract
4 Option
terms and
Purchase Undertaking (PU) conditions Bond has pricing issue on asset’s embedded option
IHH
Distributable profit to be Stake of Musyarakah IH
shared semi-annually partners based on their IHL
based on an agreed profit 3 2 capital contribution of 74:26 I0
sharing ration of 99%:1% to from KLSSB (in kind) and ILH
KLSSB and Sukukholders Sukukholders (cash) IL
….
ILL
Asset volatility and term structure of asset class.
Musyarakah Venture to sell Eg equity industry index volatility
Project Lands 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 Lease Equity
Price Delivery Payment Price Delivery Payment Price Payment
Discount Immediate Advance Discount Immediate Advance Discount Advance

Negotiated Deferred Staggered Negotiated Deferred Staggered Negotiated Staggered
Mark up End of End of Mark up End of End of Mark up End of
Period Period Period Period Period
Risk Exposure to Asset

Breakdown necessary to avoid mismatch in the Islamic
bond’s risk consideration
Asset
Entity
Property Usufruct Sukuk contract is the cosmetic of the asset
Fixed Fixed On Issuer Key challenge is on data aggregation on

Floating Floating On the
Business
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
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
meor@bondweb.com.my
Pricing Specialists
Simon Ng Email Address
Tan Keang Chuan pricing@bondweb.com.my
Paige Tan
Nuraizah Harun General Line
Noor Bazlina Sharifmuddin
+603 2711 5125
Wong Yin Yee
Financial Engineer
Ken Poh
Darryl Foo
19-5 , The Boulevard, Mid Valley City, Lingkaran Syed Putra, 59200 Kuala Lumpur, Malaysia
Tel: +603 2711 5122 Fax: +603 2284 1807 Email : enquiries@bondweb.com.my

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……In the overall scheme of things,

RAM Economic Series June 2008

Meor Amri bin Meor Ayob

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