Affine term structure models: A time‐change approach with perfect fit to market curves

We address the so‐called calibration problem, which consists of fitting in a tractable way a given model to a specified term structure such as yield, prepayment or default probability curves. Time‐homogeneous affine jump diffusions (HAJD) are tractable processes but have limited flexibility; they fail to perfectly replicate actual market curves. Applying a deterministic shift to the latter is a simple but efficient solution that is widely used by both academics and practitioners. However, the shift approach may not be appropriate when positivity is required, a common constraint when dealing with credit spreads or default intensities. In this paper, we address this problem by adopting a time‐change technique. Specific attention is paid to the Cox–Ingersoll–Ross model with compound Poisson jumps (JCIR), which remains standard for modeling intensities. Our time‐changed JCIR (TC‐JCIR) is compared to the shifted JCIR (JCIR++) in various credit applications such as credit default swap (CDS), credit default swaption, and credit valuation adjustment (CVA) under wrong‐way risk (WWR). The TC‐JCIR model is able to generate much larger implied volatilities and covariance effects than JCIR++ under positivity constraints and represents an appealing alternative to the latter.