Affine term structure models : a time-changed 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 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.Comment: 44 pages, figures and table

The Pitfalls of Central Clearing in the Presence of Systematic Risk

Through the lens of market participants' objective to minimize counterparty risk, we provide an explanation for the reluctance to clear derivative trades in the absence of a central clearing obligation. We develop a comprehensive understanding of the benefits and potential pitfalls with respect to a single market participant's counterparty risk exposure when moving from a bilateral to a clearing architecture for derivative markets. Previous studies suggest that central clearing is beneficial for single market participants in the presence of a sufficiently large number of clearing members. We show that three elements can render central clearing harmful for a market participant's counterparty risk exposure regardless of the number of its counterparties: 1) correlation across and within derivative classes (i.e., systematic risk), 2) collateralization of derivative claims, and 3) loss sharing among clearing members. Our results have substantial implications for the design of derivatives markets, and highlight that recent central clearing reforms might not incentivize market participants to clear derivatives