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Affine term-structure models: A time-changed approach with perfect fit to market curves

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  • Mbaye, Cheikh
  • Vrins, Frédéric

Abstract

We address the so-called calibration problem which consists of fitting in a tractable way a given model to a specified term structure like, e.g., yield or default probability curves. Time-homogeneous jump-diffusions like Vasicek or Cox-Ingersoll-Ross (possibly coupled with compounded Poisson jumps, JCIR), are tractable processes but have limited flexibility; they fail to replicate actual market curves. The deterministic shift extension of the latter (Hull-White or JCIR++) is a simple but yet efficient solution that is widely used by both academics and practitioners. However, the shift approach is often not appropriate when positivity is required, which is a common constraint when dealing with credit spreads or default intensities. In this paper, we tackle this problem by adopting a time change approach. On the top of providing an elegant solution to the calibration problem under positivity constraint, our model features additional interesting properties in terms of implied volatilities. It is compared to the shift extension on various credit risk applications such as credit default swap, credit default swaption and credit valuation adjustment under wrong-way risk. The time change approach is able to generate much larger volatility and covariance effects under the positivity constraint. Our model offers an appealing alternative to the shift in such cases.
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  • Mbaye, Cheikh & Vrins, Frédéric, 2019. "Affine term-structure models: A time-changed approach with perfect fit to market curves," LIDAM Discussion Papers LFIN 2019005, Université catholique de Louvain, Louvain Finance (LFIN).
  • Handle: RePEc:ajf:louvlf:2019005
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    References listed on IDEAS

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    1. Cheikh Mbaye & Frédéric Vrins, 2018. "A Subordinated Cir Intensity Model With Application To Wrong-Way Risk Cva," International Journal of Theoretical and Applied Finance (IJTAF), World Scientific Publishing Co. Pte. Ltd., vol. 21(07), pages 1-22, November.
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    1. Cheikh Mbaye & Fr'ed'eric Vrins, 2019. "An arbitrage-free conic martingale model with application to credit risk," Papers 1909.02474, arXiv.org.

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    Keywords

    model calibration ; credit risk ; stochastic intensity ; jump-diffusions ; term-structure models ; time-change techniques;
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