Spring 2012 Math 425

Converting the Black-Scholes PDE

to
The Heat Equation

The Black-Scholes partial differential equation and boundary value problem is

∂V 1 ∂2V ∂V
L (V ) = + σ 2 S 2 2 + rS − rV = 0, 0 ≤ S, 0 ≤ t ≤ T
∂t 2 ∂S ∂S
V (S, T ) = f (S), 0 ≤ S, V (0, t) = 0, 0 ≤ t ≤ T .

If V is the price of a call option, then the boundary condition f (S) = max(S − E, 0), where E denotes
the strike price of the call option.
The following change of variables transforms the Black-Scholes boundary value problem into a standard
boundary value problem for the heat equation.

2τ
S = ex , t = T − 2
,
σ
σ2

V (S, t) = v (x, τ ) = v ln (S) , (T − t) .
2

The partial derivatives of V with respect to S and t expressed in terms of partial derivatives of v in
terms of x and τ are:
∂V σ 2 ∂v
= −
∂t 2 ∂τ
∂V 1 ∂v
=
∂S S ∂x
∂2V 1 ∂v 1 ∂2v
= − +
∂S 2 S 2 ∂x S 2 ∂x2
Placing these expressions into the Black-Scholes partial differential equation and simplifying we have

∂2v
 
∂v 2r ∂v 2r
= 2
+ 2
−1 − 2v .
∂τ ∂x σ ∂x σ

Setting κ = 2r/σ 2 and t = τ , the Black-Scholes boundary value problem becomes

∂v ∂2v ∂v σ2
= + (κ − 1) − κv , −∞ < x < ∞, 0 ≤ t ≤ T
∂t ∂x2 ∂x 2

v(x, 0) = V (ex , T ) = f (ex ) , −∞ < x < ∞

One more change of variables is needed in order to eliminate the last two terms on the right hand side
of the last equation. To this end set

v (x, t) = eαx+βt u (x, t) = φu ,

where we’ll pick α and β later. Computing the partials of v in terms of x and t we have
∂v ∂u
= βφu + φ
∂t ∂t
∂v ∂u
= αφu + φ
∂x ∂x
∂2v ∂u ∂2u
= α2 φu + 2αφ +φ 2
∂x2 ∂x ∂x
Placing these expressions into the partial differential equation which v satisfies, and setting

1 σ 2 − 2r
α = − (k − 1) =
2 2σ 2
 2 2
1 2 σ + 2r
β = − (k + 1) = − .
4 2σ 2

we have
∂u ∂2u σ2
= , − ∞ < x < ∞, 0 ≤ t ≤ T (1)
∂t ∂x2 2
u (x, 0) = e−αx v (x, 0) = e−αx f (ex ) , − ∞ < x < ∞ (2)

If the option is a call option, with strike price E, then f (x) = max(x − E, 0), and

u(x, 0) = e−αx max (ex − E, 0) .

It can be shown that the solution to the heat equation (1) and initial condition (2) is given by the
following integral Z ∞
1 (x−ξ)2
u(x, t) = √ u(ξ, 0)e− 4t dξ .
4πt − ∞

2
Find the value of an option, whose value at expiration equals f (S), where

 0, S < 1
f (S) = 3, 1 ≤ S ≤ 2 .
0, S > 3


σ2T σ2T
   
σ2 T
V (S, 0) = ν ln S, = eα ln S eβ 2 u ln S,
2 2

∞ (ln S−ξ)2
−
Z
2
α ln S β σ 2T 1 2
4 σ 2T
= e e q u(ξ, 0)e dξ
2
4π σ 2T −∞

Z ∞ (ln S−ξ)2
2
α ln S β σ 2T 1
= e e √ e−αξ f (eξ )e− 2σ 2 T dξ
2πσ 2 T −∞
Z ln 2 (ln S−ξ)2
2
α ln S β σ 2T 3
= e e √ e−αξ e− 2σ 2 T dξ
2πσ 2 T 0

ln(S/2)+(r−σ2/2)T
2 3S −α α2 σ 2 T
Z λ2  λ1 =
 √
β σ 2T 2 /2 σ T
= eα ln S e √ e 2 e−λ dλ
2πσ 2 T λ1  λ2 = ln S+(r−σ2/2)T
√

σ T

σ 2 +8r
= 3e− 8
T
[N (λ2 ) − N (λ1 )] .