The CRO Forum has identified 4 principles for the extrapolation of market data for market consistent valuation purposes: 1. Use all relevant observed market data where available 2. Extrapolated market data should be arbitrage-free 3. The extrapolation method should be theoretically sound 4. The extrapolation should follow a smooth path from the entry point to the unconditional ultimate long-term level. This best practice paper details considerations and best practices on how these principles can be applied to the extrapolation of interest rates, equity and interest rate implied volatility and in situation in which an option has been written on a security for which no liquidly traded options exist at all. We keep the extrapolation method as simple and pragmatic as possible while remaining within the principles. For the extrapolation of interest rate curves 5 additional principles have been developed by a Solvency II taskforce on the illiquidity premium. These principles are supported by the CRO Forum and are also discussed in this paper.
