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APPLICATION OF LAPLACE TRANSFORM IN FINANCE

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INTERNATIONAL SCIENTIFIC JOURNAL "MATHEMATICAL MODELING" WEB ISSN 2603-2929; PRINT ISSN 2535-0986

APPLICATION OF LAPLACE TRANSFORM IN FINANCE

Daci A. PhD, Tola S. PhD.
Faculty of Mathematical and Physical Engineering – Polytechnic University of Tirana
alfreddaci@gmail.com, saimir_tola@yahoo.com
Abstract: Laplace's transformation is an important chapter of Mathematical Analysis. At present it is widely used in various problems of
signal theory, physics, mechanics, electro – techniques and economics. Laplace's transformation is the simplest and most economical method
that leads directly to the required resolution of many of the various technical problems that arise when solving them. In this paper we will
become acquainted with the basic concepts of operational mathematics and its application in economy. Not many analytic solutions exist for
present discounted value problems but by using Laplace transform we can deduce some of the closed form solutions quite easily. There will
be shown the connection between the current discounted value in finance and Laplace transformation.

Keywords: LAPLACE TRANSFORM, FINANCE, PRESENT VALUE, CASH FLOW, RATE, PERIOD.

1. Introduction
Before we consider the transformation of Laplace, we analyze form (2) that we will consider below. We are now going to
the meaning of the integral of a complex function of the real determine the transformation of Laplace.
argument. Consider the product of the function f (t ) with the real argument t
Let it be f (t ) a complex function of the real t argument given with the exponential function e  pt where p is a complex number
in the segment a, b. As it is known, such a function may appear p  s  i
in the form: f (t )  u (t )  iv(t ) e  pt  f (t ) (3)

The integral of the function f (t ) in the segment a, b with the Function (3) is again a complex function of the real argument:
definition is determined by the equation
e  pt  f (t )  e  ( s i )t  f (t )  e  st  f (t )  e it 
b b b
e  st f (t ) cos t  ie  st f (t ) sin t

a
f (t ) dt   u (t ) dt  i  v(t ) dt
a a
(1)
We will now show that when a function f (t ) meets the above
Similarly, the infinite integral of that function is defined in (0, ) : conditions, then the integral
     

 f (t ) dt   u (t ) dt  i  v(t ) dt  e f (t ) dt   e st f (t ) cos t dt  i  e st f (t ) sin t dt (4)

 pt
(2)
0 0 0 0 0 0

provided that both right-side integrals are convergent.
Since the integral of a complex function of the real variable is
defined by the equations (1) or (2) by two common integrals, then
all the properties and the integration methods of the latter are true
also for the integrals of the complex functions of the real argument.
converges, even absolutely provided that: Re p  s  S 0 .
According to the definition for the convergence of the integral (4),
the existence of each of the right-side integrals is necessary and
sufficient. Let's analyze the convergence of the first.
 

 e f (t ) cos t dt  e f (t ) cos t dt 
 st  st
Below we will be dealing with the integral of the forms (1) and
(2). Considering the fact that the purpose of introducing the 0 0
operational method is mainly the implementation direction of this
 
method, we are not dwelling on the necessary conditions of M
convergence of such integrals but will be limited to the integral of
the functions f (t ) that meets these conditions: [1], [2], [3], [4]

0

 M e  st e sot dt  M e ( s  s0 )t dt 
0
s  s0

1. The function f (t ) is continuous in (0,) combined
with its derivatives up to any necessary order, with the
exception of possibly a finite number of first type of
critical points in each finite segment.
2. f (t )  0 for t  0 .
3. The function f (t ) increases in absolute value no sooner
than an exponential function. So there are numbers
M  0 and S 0  0 such that for each term t we
Similarly, the second integral on the right side of (4) is evaluated.
The integral (4) converges to the entire complex plot area p
extending to the right of the line Re p  s0 . The proving method
also follows that only the real part of the number p determines the
convergence of the integral (4).
Integral (4) defines a function of the parameter we mark F ( p),
namely:

have: f (t )  MeS0t 
F ( p)   f (t )e
 pt
dt .
The number S0 that enjoys the above quality is called the growth 0
indicator of the function f (t ) . In particular when the function
The function F ( p), is called the Laplace image of function
f (t ) is limited then it can be consider S 0  0 . The fulfillment of
f (t ) . The function f (t ) is called the original function.
the above conditions ensures the existence of many integrals of the

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As has been stated above, it follows that the fulfillment of the Ai t

above three conditions is sufficient for the function f (t ) to be Since for the function the original is Ai e i , then
p  i
original. Below we will call original only the functions that meet
those three conditions. This tightening of the class of originals is not based on the property of linearity and equation (6) we will have:
very sensible from the practical point of view.
 ( p) 
 A1e t  A2 e t  . . .  An e t
1 2 n
(7)
If F ( p), is a reflection of the function f (t ) , then it says:  ( p) 
L f (t )  F ( p ) or F ( p) 
 f (t ) To find the coefficients we: multiply the two sides of (6) with
p  1 and using the fact that  1 is the root of  ( p) i.e
Theorem. If the function F ( p), is an image, then:
 (1 )  0 , the draw (6) takes the form:
F ( p)  0 when Re p  s  
 ( p)  A2 An 
( p  1 )  A1  ( p  1 )  . . .  
Truly, it is known that a  ib  a  b  a  b
2 2  ( p)  (1 )  p 2 p n 
Now we get the limit on both sides of this draw for p 1 . It is
 

e f (t ) cos t dt  e f (t ) sin t dt A1 . So we will have:

So:  st  st
F ( p)  clear that the right-side borders will be
0 0
 ( p)  ( p)
A1  lim ( p   1 )  lim
or p 1  ( p)   (1 ) p   ( p)   (1 )
1

F ( p) 
M

M
 0 for s  
 p  1
s  s0 s  s0
from where A 
 (1 )
Based on this theorem it can be said that the necessary condition
 (1 )
1

for a given function F ( p), to be an image of a function f (t ) is to

complete the reconciliation: In the role of 1 it could be each of the roots

lim F ( p)  0  2 , . . . i , . . .  n , therefore in the general form we will have:

Re p 

 ( i )
2. Finding the original when the image is rational Ai  (8)
 ( i )
In the practice of the usage of the operational calculus, we often
find it when the function F ( p), is rational. By the end of this Based on (7) and (8) we can write the operational relation:
paragraph we will deal precisely with the problem of finding the
 ( p)   (1 )  t  (1 )  t  ( n )  t
original when the image is rational:  e  e  ... 
1
e 2 n

 ( p)   (1 )  (1 )  ( n )

b0 p m  b1 p m1  ......  bm1 p  bm  ( p)
F ( p)   (5)
a0 p n  a1 p n 1  ......  a n 1 p  a n  ( p) or

We note, first, that the rational fraction F ( p ) should be  ( p)  n  ( i )  t

  e i
(9)
regular because otherwise the condition is not met:
 ( p)  i 1  ( i )
F ( p)   0
p 
II. Among the roots of the denominator  ( p) there are such
which is necessary for the function F ( p), to be an image. So we that are repeated.
will have m  n. Let , , . . .  be the roots of the polynomial  ( p) ,
In relation to the denominator  ( p) of the fraction (5) we while the numbers a, b, . . . l indicate how many times each of
distinguish these cases: them is rooted. In this case, the polynomial  ( p) may appear in
I. The function  ( p) has only simple roots (not repeated). the form:

We mark the roots of the polynomial  ( p) with  ( p)  ( p   ) a ( p   )b . . . ( p  )l

1 ,  2 , . . . . n . Then it can be written in the form: As it is known from the expansion of regular rational fractions
into elemental fractions, each factor of the form ( p   )d
 ( p ) = ( p  1 ) ( p   2 ) . . . ( p   n ) corresponds d to the elemental fraction with denominator
while the function F ( p), can be expanded: ( p   ) d ( p   ) d 1 . . . ( p   ) .
 ( p) A1 A2 Ai An  ( p)
  . . . . . . (6)
So the function F ( p)  in this case will be presented
 ( p) p   1 p   2 p  i p n  ( p)
in the form:

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 ( p) A1 A2 A  If instead of  we take another root of the polynomial  ( p ) ,

  . . . n  
 ( p) ( p   ) ( p   )
a a 1
pa 
then according to the formula (13) we find coefficients that belong
to that root. After finding the coefficients there is no difficulty in
 finding the original. As it is well known, each term of expansion
 (10) of the form
B1 B2 Bb  (10)
 . . .  
(p  ) (p  )
b b 1
p  Bk
 ( p   ) bk 1

L1

L2 L
 ...  l  corresponds the original:
( p  ) ( p  )
l l 1
p 
 t bk
Bk e t
Let us now see how the decomposition coefficients that are (b  k )!
marked with the same letter are counted, e.g. coefficients B.
Similarly, coefficients that are written in other letters are calculated.  ( p)
Then the original corresponding to the function
Multiply both sides of the equation (10) with (p  ) b
:  ( p)
deduced in form (10) is:
 ( p)
(p  ) b
 B1  B2 ( p   )  . . .  Bl ( p   ) b1  ( p   ) b  ( p) t  1 t t   2 t 
 ( p) A1 e  A2 e  . . .  A et  
(11) (  1)! (  2)! 

 ( p) denotes the sum of all elementary expansions (10) that does 
t b 1 t t   2 t
not belong to coefficients B. There is no factor of the form  B1 e  B2 e  . . .  Bb e  
t

(b  1)! (   2)! 
( p   ) in the denominator  ( p ) , so the denominator is not  (14)
p   . Taking the 
canceled for limits of both sides of the
. . . . . . . . . . . . 
equation (11) for p   to find: 


  ( p)  t l 1
t l 2

B1  lim ( p   ) b  L1 e  t  L2 e t  . . .  Ll e t
 ( p) 
(12)
p
 (l  1)! (l  2)! 

We now derive both sides of (11) in relation to p , then we 
have: Remarks: If in formula (13) we get b  1, then we will certainly
d  ( p)  have k 1 and this formula results in the same formula (8). For
( p   )b   B2  2 B3 ( p   )  . . .  b ( p   ) b1 ( p)  ( p   ) b  ( p) this reason, if in the expansion of the polynomial  ( p ) some
dp   ( p) 
roots are simple, then for finding the respective coefficients use the
formula (9).
Considering again the limits of both sides for p we find:

d   ( p)  3. The Accumulated Value

B2  lim ( p   )b
p dp   ( p) 
If matured interest is added to the principal at the end of each
period for which the interest is calculated and then this interest
Let k be any number from 1 to b. We derive both sides of earns interest, it is said that the interest is compounded. The
(11) in relation to p , k 1 times and find: amount of initial principal and total interest is called the
compound sum or accumulated value. [5]
d k 1   ( p) 
k 1 
( p   )b  (k  1)! Bk  . . .  (b  1) (b  2) . . . (b  k  1) Bb ( p  b) bk 1 Let's note:
dp   ( p)  P  theinitial principal or the discounted value of S
S  the sum of P ' s or accumulated value of P


d k 1

 k 1 ( p  b) b  ( p)
dp
t  total number of interest periods
r  interest rate
We move to the limit for p   on both sides of the above Let P be the principal at the beginning of the first period and r
equation. It is clear that on the right side it will remain the interest rate for the conversion period. We will calculate
(k  1)! Bk alone and if we devide it with the (k  1)! we find: accumulated values at the end of consecutive periods of conversion
for t periods.

At the end of the first period:

1 d k 1   ( p)  Interest matured P r
Bk  k 1 
( p   )b
 ( p) 
lim (13)
(k  1)! p   dp  The accumulated value P  P  r  P(1  r )

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At the end of the second period: k2

quantity k 2 after two years; k2  P(1  r ) 2  P 
Interest matured  P  (1  r)  r (1  r ) 2
, and

The accumulated value so on. The full amount that needs to be deposited today, so that all
P(1  r )   P  (1  r )  r  P(1  r )2 payments are covered is:
At the end of the third period:
k1 k2 k3 kt
Interest matured  P  (1  r ) 2   r Pt     ...  (21)
1  r (1  r ) (1  r )
2 3
(1  r )t
The accumulated value
If the payments are the same, k1  k2  k3  ...  k t  k then
P(1  r ) 2   P  (1  r ) 2   r  P(1  r )3
k k k k
Pt     ...  (22)
Continuing this way we would get the accumulated values: 1  r (1  r ) (1  r )
2 3
(1  r )t
P(1  r ), P(1  r ) 2 , P(1  r )3 ,... 1
This is nothing but a series of geometric progression at a time
1 r
They form a geometric progression t whose term is: that;
1
S  P(1  r )t (15) 1
k (1  r )t k  1 
Pt    1   (23)
1 r 1 1 r  (1  r )t 
4. Relation Between Present Value and Laplace 1 r
If we use Laplace transformation
Transform 
k
In business transactions it is usually necessary to determine the
L k   k  e  rt dt  (24)
0
r
level of principal P today, that will be accumulated at a compound
interest rate r in a given sum S on a given date (t interest period Example. Estimate the current value of a $ 1000 instant spill series
from that moment). By formula (15) at the end of each year when the annual interest rate is 10%.
k 1000
we have: Solution: P    10000$
T
r 10%
S (t )
P (16)
t 1 (1  r )
t

In other words, it is the amount that we would be willing to pay 4. Conclusions

today in order to receive a cash flow or a series of them in the
1) Laplace transformation is the simplest and most
future. [6] Now by using an exponential series we can write
economical method that leads directly to the required
equation (16) as,
resolution of many of the various technical problems that
T arise when solving them.
P   e rt S (t ) (17) 2) Using the Laplace transformation we easily obtain a
t 1 definitive analytical solution to the problems of the
present discounted value where was shown the close
In the limiting case replacing summation to an integral,
relationship existing between the actual discounted value
equation (17) can be written as
in finance and the transformation of Laplace. [6]
T 3) The result in this paper increases the practical benefits of
P   e  rt S (t ) dt (18) Laplace transformation particularly in finance.
0 4) Laplace transformation is the major resource for
discounted value functions to illustrate complex
Again here T is some finite quantity. So if we consider as problems.
T   , equation (18) will becomes


e
 rt 5. References
P S (t ) dt (19)
0
1. Jorgo Malita, Analiza Komplekse, Tiranë 2009.
Equation (19) is nothing other than the definition of Laplace's 2. Joel L. Schiff, The Laplace Transform, Theory and
transformation, hence: [6] Applications, Springer 1999.
3. Marcel B. Finan, Laplace Transforms: Theory, Problems,
P (r )  LS (t ) (20) and Solutions, Arkansas Tech University.
4. C.T.J. Dodson, Introduction to Laplace Transforms for
Suppose successive t payments are to be made, k1 , k2 , k3 ,..., k t Engineers, School of Mathematics, Manchester
University.
where: k1 to be settled after a year, k 2 after two years and so on. 5. Omer Stringa, Matematika Financiare, Pegi, Tiranë 2004.
How much is the amount to be deposited today in one bank account 6. N. A. Patil, Vijaya N. Patil, Application of Laplace
in order to get enough savings to afford all future payments when Transform, Global Journals Inc. (USA), Online ISSN:
the annual interest rate is r. 2249-4626 & Print ISSN: 0975-5896, Volume 12 Issue
So what is the present value of all payments? 12 Version 1.0 Year 2012.
We start from formula (15) and apply it for the foregoing. To have
the quantity k1 after one year we have: k1  P(1  r ) , from where,
k1
the amount we need to deposit today is P  . To have the
1 r

133 YEAR II, ISSUE 4, P.P. 130-133 (2018)

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