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An analysis of the Solvency II regulatory framework’s Smith-Wilson model for the term structure of risk-free interest rates

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  • Jørgensen, Peter Løchte

Abstract

In the European Union financial regulation requires that life and pension (L&P) companies use the Smith and Wilson (2000) model for the term structure of risk-free interest rates when valuing their liabilities and long term guarantees. Some key features of this model are that it allows for a perfect fit to market observed bond prices, and that its extrapolated long rates converge towards a constant level, the Ultimate Forward Rate (UFR). Both this level and the rate at which convergence towards it takes place are directly specified via parameters of the model. Since the Smith–Wilson model is not one of finance theory’s standard term structure models, we introduce the model and summarize its most important mathematical properties. We also describe how the European Solvency II regulation came to embrace this particular model.

Suggested Citation

  • Jørgensen, Peter Løchte, 2018. "An analysis of the Solvency II regulatory framework’s Smith-Wilson model for the term structure of risk-free interest rates," Journal of Banking & Finance, Elsevier, vol. 97(C), pages 219-237.
    • Handle: RePEc:eee:jbfina:v:97:y:2018:i:c:p:219-237
    DOI: 10.1016/j.jbankfin.2018.10.001
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    References listed on IDEAS

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    Cited by:

    1. Magomet Yandiev, 2021. "Risk-Free Rate in the Covid-19 Pandemic: Application Mistakes and Conclusions for Traders," Papers 2111.07075, arXiv.org.
    2. Zhao, Chaoyi & Jia, Zijian & Wu, Lan, 2024. "Construct Smith-Wilson risk-free interest rate curves with endogenous and positive ultimate forward rates," Insurance: Mathematics and Economics, Elsevier, vol. 114(C), pages 156-175.

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    More about this item

    Keywords

    Solvency II; Financial regulation; Term structure of interest rates; Calibration; Market valuation;
    All these keywords.

    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G22 - Financial Economics - - Financial Institutions and Services - - - Insurance; Insurance Companies; Actuarial Studies
    • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation

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