On Approximation of the Solutions to Partial Differential Equations in Finance

Akihiko Takahashi and Toshihiro Yamada
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Akihiko Takahashi: Faculty of Economics, University of Tokyo
Toshihiro Yamada: Mitsubishi UFJ Trust Investment Technology Institute Co.,Ltd.

No CIRJE-F-815, CIRJE F-Series from CIRJE, Faculty of Economics, University of Tokyo

Abstract: This paper proposes a general approximation method for the solutions to second-order parabolic partial differential equations (PDEs) widely used in finance through an extension of Léandre's approach(Léandre (2006,2008)) and the Bismut identiy(e.g. chapter IX-7 of Malliavin (1997)) in Malliavin calculus. We show two types of its applications, new approximations of derivatives prices and short-time asymptotic expansions of the heat kernel. In particular, we provide new approximation formulas for plain-vanilla and barrier option prices under stochastic volatility models. We also derive short-time asymptotic expansions of the heat kernel under general time-homogenous local volatility and local-stochastic volatility models in finance which include Heston (Heston (1993)) and (λ-)SABR models (Hagan et.al. (2002), Labordere (2008)) as special cases. Some numerical examples are shown.

Pages: 44 pages
Date: 2011-08
New Economics Papers: this item is included in nep-ore
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Citations: View citations in EconPapers (3)

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