Marking to Market Pricing in Korea

1. Marking to Market Pricing in Korea Hong WoosunCEO & President, KIS Pricing, Inc. 2007.11.15

2. Contents I. The Establishment of the MTM Pricing in Korea II. Pricing Workflow III. Challenges

3. 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

4. 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

5. 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.

6. 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 2000 Establishment of Pricing Agency 2001 Asset Management Companies Trust Account of Banks 2002 RP of Security Companies 2003 Trust Account of Insurers 2007

7. 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 * As of end of October ,2007

8. 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.)

9. 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

10. W o r k f l o w Collecting trade/quote data Pricing Verifying the outcome Delivering information Market Feedback & Data Application DB build-up for issuing information DB build-up based on accurate issuing information Real-time market trading data, and quotation for non-traded bonds [Straight bond]pricing usingindividual YTM oryield curves [Structured bond]pricing usingmathematical models Examining through verification process Providing customized information Regular monitoring through broker- dealer network & customers II. Pricing Workflow

11. KOSCOM (issuing & trading info.etc.) Cleansing DB contacting issue institutions KSD ( Info of standardized issuing bond, balance unsettled and standardized issuing CP etc.) KIS Pricing Closing DB KIS Pricing (DB) Pricing Platform KIS INFO (info about company, stock etc.) II. Pricing Workflow DB build-up for issuing information Collecting trade/quote data Pricing Verifying the outcome 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

12. DB Build-up • Collecting real-time data from KOSCOM which is comprised of transaction data in Exchanges & OTC market • 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 DBafter eliminating outliers Secondary Market Info. Primary Market Info. • Collecting yield info. from the network of primary market such as- Bond issuing firms(financial institutes, public utilities,corporations) - Investment bank dealers II. Pricing Workflow DB build-up for issuing information Collecting trade/quote data Pricing Verifying the outcome Delivering information Market Feedback & Data Application

13. BrokerageHouses Sell Side Mangers(Bid & Ask Quotes) Buy Side Mangers(Bid & Ask Quotes) KISP receives quotes fromdealer & broker networks 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

14. 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. Present Early Stages • active / sensitive response from clients All Securities Subject to Yield Curve Pricing Based on Yield Curve • increase in liquid sectors in bond market Based on Individual YTM

15. 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) - 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 for continuity of spot curve at kinked point Yield Maturity

16. 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 (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 Yield Curve Estimation 3M …. 5Y Dailytrade & quote Data Estimationusing cubic spline fn. Gov’t 5.42 6.23 ……. hypothetical bond (par bond) Public 5.63 6.78 yield change in gov’t sector

17. 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 information of firmwith similar credit quality YTM Matrix Yield Curve Estimation Trade & QuoteData of Issuing Firm Estimationusing cubic spline fn. Credit Quality ofIssuing Firm(PD,LGD) hypothetical bond (par bond) yield on previous dayyield change in govt sector

18. II. Pricing Workflow DB build-up for issuing information Collecting trade/quote 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 Primary Verification by Pricing Staff Secondary Verification By Market Specialist - Feedback from market transactions and checking the yield variations - Verifying pricing results according to security types Updating the Modified Data • 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.

19. 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

20. 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

21. Increase in securities that require hard pricing - non-listed securities - defaulted or work-out bond- real asset related securities 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 - Regulation with respect to financial reporting- Strict risk management standards - Mandatory data for Fund NAV calculation- Basic data for bond trading- Reference data for bond issuance 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

22. 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

23. 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) -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) The need to activate the corporate bond market (relatively inactive compared to gov’t bond market)and develop the credit derivatives market (KIS Pricing) Play major role & function as Credit Information Center Activation of Corporate Bond Market and Credit Derivatives Market - 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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