METHOD AND SYSTEM FOR STRESS TESTING SIMULATIONS OF THE BEHAVIOR OF FINANCIAL INSTRUMENTS

A method and system for simulating changes in volatility for a price of a particular option on an underlying financial instrument is disclosed. A volatility surface model having at least one surface parameter is provided along with a set of volatilities for a plurality of options on the underlying financial instrument. The set of volatilities is analyzed to determine an initial value for each surface parameter which, when used in the surface model, defines a surface approximating the set of volatilities under normal market conditions. The values of the surface parameters are then evolved using an appropriate evolution function. Prior to applying the surface parameters to the model, the parameter values can be adjusted to introduce changes in offset, skew, term, or other parameters of the volatility surface to allow for simulation of unusual market conditions. A volatility value for a particular option is extracted from the volatility surface defined by the evolved and stress-adjusted surface parameter values. The extracted volatility value can then be used in an option pricing model to provide a price of the particular option.