Marking to Market Pricing in Korea
Hong Woosun
CEO & President, KIS Pricing, Inc.
2007.11.15
Contents
I. The Establishment of the MTM Pricing in Korea
II. Pricing Workflow
III. Challenges
2
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KIS Pricing, Inc.
I. The Establishment of Marking to Market Pricing in Korea
The Introduction of MTM Pricing System
 Asian Financial Crisis
- Financial system breakdown
… Monetary policy ineffective and futile
… Firms unable to raise capital
- Insolvency of financial institutions was mainly caused by deficient bond market
… Fair valuation of fund NAV was unavailable.
… Selling of bond holdings was difficult or impossible.
- Large amount of public capital was expensed to restructure asset management companies.
 Government Established “Task Force for Activating Fixed Income Market” (2000.02)
- Development of the bond market (benchmark: US & other developed markets)
 Building up a reliable and sound financial market
- Government sought measures to improve and alleviate regulatory framework
… Established Bond Pricing Agency as a plan to develop the bond market infrastructure
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KIS Pricing, Inc.
I. The Establishment of Marking to Market Pricing in Korea
Difficulties Faced throughout the Initiating Process

Resistance from Market Participants
- Fund managers felt the burden of daily price changes of investment assets.
- Middle & back offices felt the burden of employing new system

Insufficient Pricing Infrastructure and Experience
- Lack of infrastructure to perform the MTM Pricing
- Lack of experienced experts

Lack of Bond Trade Information
- Insufficient data for building the yield curve
- System unprepared for collection and management of trade information
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KIS Pricing, Inc.
I. The Establishment of Marking to Market Pricing in Korea
Role of Regulatory Body during the Initiating Stages
 Resistance from market participants of implementing the MTM Pricing
- Regulatory action had an essential role for implementing the MTM pricing.
- From July 2001, all trust fund accounts were legally mandated to disclose NAV
using evaluated prices from 2 or more bond pricing agencies.
- Gradual mandate to the MTM pricing rather than the implementation at once
 Insufficient Market Pricing Infrastructure and Experience
- Government imposed strict requirement for pricing agency registration.
- The government regularly monitors the quality of the service.
 Lack of Secondary Market Information
- Official designation by government to concentrate the market information on KSDA
- Bond pricing agency can obtain relevant accurate information promptly from KSDA.
Problems were solved through support and regulatory action by the Regulators.
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KIS Pricing, Inc.
I. The Establishment of Marking to Market Pricing in Korea
Current Roles and Coverage of MTM Pricing Agency in Korea

Uses of MTM Pricing
- The MTM pricing were initially used only for AMCs according to the regulatory mandate.
- All financial institutions currently evaluate NAV of funds using the price of pricing agency.
(Regulatory actions to mandate MTM pricing)
1998 Introduction of MTM Pricing
AMCs
All Accounts
Mandatory
2000
Banks
Trust Account
Mandatory
Others
Voluntary
Separate
Account
Mandatory
Others
Voluntary
Security
Companies
RP Account
Mandatory
Others
Voluntary
Pension Funds
All Accounts
Voluntary
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KIS Pricing, Inc.
2001
2002
Establishment of Pricing Agency
Asset Management Companies
Trust Account of Banks
Insurance
Companies
RP of Security Companies
2003 Trust Account of Insurers
2007
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I. The Establishment of Marking to Market Pricing in Korea
Current Roles and Coverage of MTM Pricing Agency in Korea

Pricing Coverage
Now, we are pricing all securities held by financial institutions.
… Equity-linked securities, option-embedded bonds in addition to straight bonds
… CD/CP as MMF funds are mandated to receive MTM pricing services
… Global bonds as global investments increase in Korean capital market
… Derivatives pricing due to strengthening of risk management standards
Type
Straight
Bonds
Non-straight
Bonds
Coupon Bonds,
Compound
Bonds,
Discount Bonds,
Junk Bonds
Equity Linked Notes
(ELS,CB, BW),
Floating Rate
Notes(FRN),
Asset-Backed
Securities
7,630
5,810
Money Market
Asset
Foreign Currency
Denominated Bond
OTC Derivatives
New Products
Certificate of
Deposits,
Commercial
Papers
On/Off-shore issues of
Korean gov’t, domestic, and
foreign firms
Interest Rate Swap,
Currency Rate
Swap, Asset Swap,
Credit Default Swap,
FX Forward, and other
OTC contracts
Inflation or
currency Linked
Notes,
Credit Linked
Notes(CDO,CDS,
CBO), DLS and
etc.
830
3,320
6,050
100
Items*
23,740
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* As of end of October ,2007
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KIS Pricing, Inc.
I. The Establishment of Marking to Market Pricing in Korea
Extended Roles of Bond Pricing Agencies in Korea

Evaluated prices are used as standard value for trading
 Dealers and brokers voluntarily discuss pricing issues with the pricing agency.

Act as an information warehouse in the financial market
… Providing Bond Index and Risk Management Data

Promote to the development of financial market infrastructure
… Providing pricing engines and asset management systems (solutions)

Contribute to the growth of financial knowledge and expertise in the market
… Providing consulting services (pricing methodologies, risk management, and etc.)
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KIS Pricing, Inc.
II. Pricing Workflow
Pricing Principles
 Market Priority
- Collecting all the available trading data on the secondary market through KSDA
- Collecting as much bid-ask offer information as possible
- Getting feed back from dealers and brokers on accuracy of prices
 Our ultimate mission is to provide prices that can be utilized in actual trading.
 Fair Valuation
- Using mathematical models based upon yield curves and credit quality of issuers
- Obtaining market consensus through discussions with dealers, brokers and analysts
 Fair valuation for iIliquid bonds
 Fully Reliable Database
- Collecting as much data as possible (data source : KOSCOM, KSDA and KIS INFO)
- Double checking with issuers and other market participants
 Collecting accurate market data is the key to generating accurate prices.
Providing impartial and objective prices to Improve information transparency
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KIS Pricing, Inc.
II. Pricing Workflow
DB build-up
for
issuing
information
W o r k f l o w
DB build-up
based on
accurate
issuing
information
Collecting
trade/quote
data
Real-time
market trading
data, and
quotation
for non-traded
bonds
Pricing
[Straight bond]
pricing using
individual YTM or
yield curves
[Structured
bond]
pricing using
mathematical
models
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Verifying
the outcome
Delivering
information
Examining
through
verification
process
Providing
customized
information
Market
Feedback &
Data
Application
Regular
monitoring
through
broker- dealer
network &
customers
www.bond.co.kr
KIS Pricing, Inc.
II. Pricing Workflow
DB build-up
for
issuing
information
Collecting
trade/quote
data
Verifying
the outcome
Pricing
Delivering
information
Market
Feedback &
Data
Application

Data Source
- KSDA and KOSCOM (Korea Securities Computer Corp) :
general information such as bond issuing & trading data and outstanding amount of bonds
- KIS-INFO : Financial statements of domestic firms

Data Filtering : Collecting information from bond issuers

Data Updating : Daily updating the data on new issuances
KOSCOM
Cleansing DB contacting
issue institutions
(issuing & trading
info.etc.)
KSD
( Info of standardized
issuing bond, balance
unsettled and standardized
issuing CP etc.)
KIS Pricing (DB)
Pricing Platform
KIS Pricing
Closing DB
KIS INFO
(info about company,
stock etc.)
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KIS Pricing, Inc.
II. Pricing Workflow
DB build-up
for
issuing
information
Collecting
trade/quote
data
Pricing
Verifying
the outcome
Market
Feedback &
Data
Application
Delivering
information
 Collecting real-time data from KOSCOM
which is comprised of transaction data in Exchanges & OTC market
Secondary
Market
Info.
 Collecting bid-ask information from the bond market via
- Yahoo, MSN, Cybos Messenger
- the network of major brokerage houses
 Collected trade and quote data are stored in KIS Pricing DB
after eliminating outliers
Primary
Market
Info.
DB
Build-up
 Collecting yield info. from the network of primary market such as
- Bond issuing firms(financial institutes, public utilities,corporations)
- Investment bank dealers
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KIS Pricing, Inc.
II. Pricing Workflow
DB build-up
for
issuing
information
Collecting
trade/quote
data
Pricing
Verifying
the outcome
Delivering
information
Market
Feedback &
Data
Application
Transaction Data from KOSCOM
Under the regulation, brokerage houses must submit quoted (traded) information to KSDA,
which are delivered to KOSCOM
Trade & Quote Data from Dealer Quotes
 Exchange Market : Less than 20% (mostly government bonds)
 OTC Market : over 80%
Quotes are disclosed over the telephone or Yahoo! Messenger
Buy Side Mangers
(Bid & Ask Quotes)
Brokerage
Houses
Sell Side Mangers
(Bid & Ask Quotes)
KISP receives quotes from
dealer & broker networks
13
www.bond.co.kr
KIS Pricing, Inc.
II. Pricing Workflow
DB build-up
for
issuing
information
Collecting
trade/quote
data
Pricing
Verifying
the outcome
Delivering
information
Market
Feedback &
Data
Application
Coverage of Yield Curve Pricing

During the early stages of MTM pricing, all securities were priced based on
estimated yield curves .

As the prices from the pricing agency are used as reference prices in the market,
clients become more sensitive to the price of individual bonds.

Out of 7,630 straight bonds being priced, approximately 200 bonds are evaluated
by individual bond YTM observed in the market (government and public bonds).
… This portion of YTM usage in pricing is expected to increase continuously.
Early Stages
All Securities Subject to
Yield Curve Pricing
-active
/ sensitive
response from clients
Present
Based on Yield Curve
-
increase in liquid sectors
in bond market
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Based on Individual YTM
www.bond.co.kr
KIS Pricing, Inc.
II. Pricing Workflow
DB build-up
for
issuing
information
Collecting
trade/quote
data
Pricing
Verifying
the outcome
Delivering
information
Market
Feedback &
Data
Application
Function for Yield Curve Estimation
 We use piecewise cubic polynomial function to estimate yield curve(zero-coupon curve)
r (ti )   (1 ti )  ln(a0  a1ti  a2ti2  a3ti3 )

- The cubic spline method helps incorporate possible humps in the yield curve, thereby
reducing possible error that can result from interpolation.
- By introducing piecewise procedures, based on maturity, we can increase the parameters
to enhance the goodness of fit.
Yield Curves are generated based on credit ratings of issuers
- Generated yield curves are also used for derivatives pricing
r i r j  2 r i  2 r j

,
 2 for continuity of spot curve at kinked point
t
t t 2
t
Yield
r j (t )  (1 t )  ln(a0j  a1j t  a2j t 2  a3j t 3 )
r i (t )  (1 t )  ln(a0i  a1i t  a2i t 2  a3i t 3 )
Maturity
ti
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KIS Pricing, Inc.
II. Pricing Workflow
DB build-up
for
issuing
information
Collecting
trade/quote
data
Verifying
the outcome
Pricing
Delivering
information
Market
Feedback &
Data
Application
Estimation Process (government bond, public bond etc)
 These sectors are more liquid compared to corporate sector.
- However, they lack trade data to fit the curve directly.
- Outliers must be carefully eliminated to ensure prices do not fluctuate to irrational levels

Due to the lack of trade data and existence of outliers, we developed a YTM matrix
instead of directly deriving the yield curve from the trade data.

We then use the YTM matrix to estimate the yield curve
yield on
previous day
YTM Matrix
3M
Daily
trade & quote
Data
Gov’t
….
Yield Curve Estimation
5Y
5.42
6.23
5.63
6.78
…….
Public
yield change
in gov’t sector
16
hypothetical bond
(par bond)
www.bond.co.kr
Estimation
using
cubic spline fn.
KIS Pricing, Inc.
II. Pricing Workflow
DB build-up
for
issuing
information
Collecting
trade/quote
data
Pricing
Verifying
the outcome
Delivering
information
Market
Feedback &
Data
Application
Estimation Process (corporate sector including financial institutions)



For corporate bonds, trade & quote information is scarce,
therefore we generate YTM matrix of issuing firms based on credit quality.
To complement for the liquidity problem, we use trade and pricing information of
firms with similar credit ratings, and apply them in pricing of illiquid bonds.
We estimate yield curves of each firm using the corporate YTM Matrix.
Trade & Quote
Data of Issuing Firm
Credit Quality of
Issuing Firm(PD,LGD)
trade information of firm
with similar credit quality
YTM Matrix
3M
Firm A
….
Yield Curve Estimation
5Y
5.92
6.83
6.23
7.28
…….
Firm B
yield on previous day
yield change in govt sector
17
hypothetical bond
(par bond)
www.bond.co.kr
Estimation
using
cubic spline fn.
KIS Pricing, Inc.
II. Pricing Workflow
DB build-up
for
issuing
information
Collecting
trade/quote
data
Primary Verification
by Pricing Staff
Secondary Verification
By Market Specialist
Updating the
Modified Data
Pricing
Verifying
the outcome
Delivering
information
Market
Feedback &
Data
Application
- Systematic verification by using developed price trend analyzer
- Review of programs and modules to check for possible errors
- Feedback from market transactions and checking the yield variations
- Verifying pricing results according to security types
- If pricing error is found in one of two previous verification processes,
re-pricing process is initiated and error is corrected and updated to DB.
Final Verification
The above verification processes enhance accuracy and reliability of the pricing outcomes.
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KIS Pricing, Inc.
II. Pricing Workflow
DB build-up
for
issuing
information
Collecting
trade/quote
data
Pricing
Verifying
the outcome
Delivering
information
Market
Feedback &
Data
Application
 Delivery of Pricing Results via
- File Transfer Protocol (FTP)
- Email and Data feed according to customized format for clients
 Stability of Computer Equipment
- Our backup system guarantees the stability of hardware.
- Main server is physically located away from backup server to promptly cope with emergencies.
- Firewall keeps our system highly secure.
 Stability of Network
- Building the backup line for communication equipment
- Constructing T3(30M) & high speed line Metro(30M)
 Quickness of Data Delivery Services
Prompt delivery of pricing data for our clients’ convenience
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KIS Pricing, Inc.
II. Pricing Workflow
DB build-up
for
issuing
information
Collecting
trade/quote
data
Pricing
Verifying
the outcome
Delivering
information
Market
Feedback &
Data
Application
We run a monitoring group for better communication with the market
 Roles of monitoring group
- Monitoring the movement of current bond market
- Asking the market participants for feedback to get the prices acceptable in the market
 Monitoring group composed of participants in bond market
- Over 20 members currently working at asset management companies, banks and
securities companies
- Continuously exchanging views with specialists on market situation
- Collecting the bid-offer quotations of illiquid bonds
KIS Pricing is always open to price challenges from our clients
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KIS Pricing, Inc.
III. Challenges
Increase in Price Challenges from Market Participants
 Increase in price challenges as our prices are more widely used
 Strict financial reporting / RM standards  increase in number of hard pricing securities
Conventionalized use of bond agency prices
- Mandatory data for Fund NAV calculation
- Basic data for bond trading
- Reference data for bond issuance
- Regulation with respect to financial reporting
- Strict risk management standards
Increase in securities that require hard pricing
- non-listed securities
- defaulted or work-out bond
- real asset related securities
Market participants anticipate prices to be
decided on their interests
Increase in Price Challenges
(KIS Pricing)
- Strengthened monitoring of pricing processes
- Collecting and Managing information about hard pricing securities
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KIS Pricing, Inc.
III. Challenges
Regulatory Effort to Promote Transparency in Bond Secondary Market
 Remedy for information asymmetry of traded data and lack of transparency
 Convergence of trade/quote information by regulation  widespread exchange trading
(Remedy by regulation)
Information asymmetry of traded data
and lack of transparency caused by
Excessive OTC / Messenger Trading
- Giving a favor to primary dealer dealing in Exchange
- Convergence of trading/quote information to KSDA
- Electronic Trading System (under consideration)
Concentration and
Sharing of Secondary
Market Information
(KIS Pricing)
- Decrease in information collecting cost
- Pricing coverage by yield curve will be decreased.
- Need to revise our existing pricing methodology and process
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KIS Pricing, Inc.
III. Challenges
Regulatory Effort to Activate the Corporate Bond Market
 Regulatory aid to promote the issuance of corporate bonds
 Strong foundation for credit derivative market through the development of the corporate bond
 KIS Pricing expects our price to act as market standard in illiquid sectors.
(Support in the form of Regulatory Systems)
The need to activate the corporate bond market
(relatively inactive compared to gov’t bond market)
and develop the credit derivatives market
-IB business reinforced through capital market reform
-Tax incentive for high yield funds
-Corporate bond investment funds introduced (expected)
-Initiation of fund credit ratings by regulation (expected)
(KIS Pricing)
Play major role & function as Credit Information Center
- Development of DB for credit information
(e.g., default probability, recovery rate)
- Role as a price signal reflecting corporate credit quality
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Activation of
Corporate Bond Market and
Credit Derivatives Market
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KIS Pricing, Inc.
Thank You !
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KIS Pricing, Inc.