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Solution techniques
u(x, 0) = u0 (x)
Ṫ (t) 1 X ′′ (x) 1
= =: κ.
T (t) 2 X (x) 2
Therefore
1
T (t) = T (0)e 2 κt
and the asymptotic behaviour indicates 0 > κ =: −ω 2 . Then
n=1
if u = 0 at x = 0, π.
This only works (for periodic initial values or) on a finite interval,
and is therefore of limited use for most applications in finance.
and Z ∞
u(x, 0) = g (ω)e−iωx dω.
−∞
Thus define the Fourier transform
Z ∞
ˆ 1
f (ω) = √ f (z)eiωz dz
2π −∞
with inverse Z ∞
1
f (z) = √ fˆ(ω)e−iωz dω.
2π −∞
∂û c
∂u 1 ∂d
2u 1
= = 2
= − ω 2 û.
∂t ∂t 2 ∂x 2
As before, we get an ODE in t with solution
1 2
û(ω, t) = û(ω, 0)e− 2 ω t ,
∂2u ∂2u
+ =0
∂x12 ∂x22
is an elliptic equation,
∂2u ∂2u
− =0
∂x12 ∂x22
hyperbolic.
x = λX
t = λ2 T
as √ √ √
x/ t = λX / λ2 T = X / T .
√
Indeed, for ξ = x/ t
f ′′ = −ξf ′ ,
with solution Z ξ
2 /2
f =A e−s ds + B.
−∞
and now
1 1
αf − ξf ′ = f ′′ .
2 2
Thus Z ∞
lim uδ (y , t)f (y ) dy = f (0).
t→0 −∞
∂u 1 ∂2u
= , u(x, 0) = f (x)
∂t 2 ∂x 2
is Z ∞
1 2 /2t
u(x, t) = √ e −(x−y ) f (y ) dy .
2πt −∞
Note that this solution blows up if we put t < 0 into it.
Sam Howison and Christoph Reisinger Partial Differential Equations
Black-Scholes
Now consider the Black-Scholes equation
∂V 1 ∂2V ∂V
+ σ 2 S 2 2 + (r − D)S − rV = 0
∂t 2 ∂S ∂S
We could look for separable solutions of the form
∂V ∂V ∂2V
= f (S)ġ (t), = f ′ (S)g (t), = f ′′ (S)g (t)
∂t ∂S ∂S 2
which gives
and
1 2 2 ′′
2 σ S f (S) + (r − D)Sf ′ (S) − λf (S) = 0.
These are a first order linear and an Euler equation for g (t) and
f (S) respectively.
Having observed this, a slightly easier way to go about it is to try a
solution of the form
V (S, t) = e αt S β .
There is a very important simple case, where we consider
f (S) ∝ S
ġ (t) = Dg (t)
∂V ∂2V ∂V
+ 21 σ 2 2 + (r − D − 21 σ 2 ) − rV = 0
∂t ∂x ∂x
We could now look for solutions V = V (t), V = V (x) and
V = F (x)g (t), but this would produce nothing new.
Sam Howison and Christoph Reisinger Partial Differential Equations
More similarity solutions
∂V
= −cf ′ (x − ct)
∂t
∂V ∂2V
= f ′ (x − ct), = f ′′ (x − ct)
∂x ∂x 2
where ′ denotes the derivative with respect to the argument of f .
Then we would obtain the second order ordinary differential
equation
1 2 ′′ 1 2 ′
2 σ f + (r − D − 2 σ − c)f − rf = 0
Now write
x ′ = x − kt, t′ = t
so
∂ ∂t ′ ∂ ∂x ′ ∂ ∂ ∂
= ′
+ ′
= ′ − k ′,
∂t ∂t ∂t ∂t ∂x ∂t ∂x
∂ ′
∂t ∂ ′
∂x ∂
= ′
+
∂x ∂x ∂t ∂x ∂x ′
and
∂2 ∂2
= .
∂x 2 ∂x ′ 2
Then we find that
∂U 2
1 2∂ U ∂U
′
+ 2 σ 2
+ (r − D − 12 σ 2 − k) ′ = 0.
∂t ∂x ′ ∂x
∂U 2
1 2∂ U
+ 2 σ = 0.
∂t ′ ∂x ′ 2
Finally, note that an option usually has an expiry date T
associated with it. If we write
τ = σ 2 (T − t ′ )
so
∂ ∂τ ∂τ ∂
= ′ ′ = −σ 2
∂t ′ ∂t ∂t ∂τ
we arrive at the heat equation or diffusion equation
∂U ∂2U
= 21 ′ 2 .
∂τ ∂x
V (S, t) =
e rt Û log(S) − (r − D − 21 σ 2 )t, σ 2 (T − t) .
Note that there are other ways of reducing the Black–Scholes
equation to the heat equation; this is just a relatively simple
method to show that it is possible. One solution can be written
down directly — if Û(x ′ , τ ) ∝ x we get the so-called
“log-contract”. If V = Z log(S/K ) at time t = T the solution to
the BS eqn with this terminal value is:
V (S, t) =
Ze −r (T −t) log(S) + (r − D − 12 σ 2 )(T − t) .
Properties of solutions
ut + aux = 0,
DT := (0, L) × (0, T ),
∂u ∂u ∂2u
(x∗ , t∗ ) = 0 (x∗ , t∗ ) = 0 and (x∗ , t∗ ) ≤ 0.
∂t ∂x ∂x 2
First consider
1
ut − uxx = F
2
with F (x, t) < 0.
Then it follows
which is a contradiction.
Now consider
1
ut − uxx = 0
2
and put v = u + ǫx 2 so
1
vt − vxx = −ǫ < 0
2
and v cannot have an interior maximum. Letting ǫ → 0 we see
u ≤ max u.
BT
∂V 1 ∂2V ∂V
+ σ 2 S 2 2 + (r − D)S − rV = 0
∂t 2 ∂S ∂S
the relevant part of the boundary is
(final value problem!), and for r > 0 the result holds in the weaker
form
max u + = max u + ,
BT ∪DT BT
A problem is well-posed, if
◮ the solution exists,
◮ it is unique, and
◮ it depends continuously on the data.
We have seen that the heat equation is well-posed.
[We have cast aside a discussion of what class of solutions we
consider, or how we measure continuity.]
is well-posed by time-reversal.
This is of fundamental importance in finance as many problems
have this structure of final value problems of a backward equation.