Post on 30-Jan-2016
description
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