The Solvency II standard formula measures interest rate risk based on two stress scenarios which are supposed to reflect the 1-in-200 year event over a 12-month time horizon. The calibration of these scenarios appears much too optimistic when comparing them against historical yield curve movements. This article demonstrates that interest rate risk is measured more accurately when using a (vector) autoregressive process together with a GARCH process for the residuals. In line with the concept of a pragmatic standard formula, the calculation of the Value-at-Risk can be boiled down to 4 scenarios, which are elicited with a Principal Component Analysis (PCA), at the cost of a relatively small measurement error.
Interest Rate Risk Principal Component Analysis Capital Requirements Solvency II