I have 2 perspectives as to what model to use for a YCS option:

  1. It is an at the expiry option, so hit the marginals, correlate them with a copula, and be done with it.

  2. To hedge the vega, I will need to have both underlyings. Moreover, I might need to rebalance the hedge in the future (say rates move, I lose/gain vega sensitivity on vanillas so I have to buy less/more of them). This should ideally be priced in the YCS (price should have some component of hedging costs), so I should probably regard this as a path dependent product and use a stock vol model.

Any advice as to which one is correct? Thanks!

Edit: I suppose this concern applies to any multivariate at the expiry payoff.

  • $\begingroup$ Wouldn't the Libor Market Model be best suited for YCS options? The LMM should take care of the correlations between the different maturities on the Yield Curve. $\endgroup$ – Jan Stuller Jun 28 at 16:53
  • $\begingroup$ So would the copula approach, or HW 2 factor. $\endgroup$ – Arshdeep Singh Duggal Jun 28 at 23:37

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