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Appendix I - Feynman Kac Formula - 2016 - Computational Finance Using C and C

The Feynman-Kac formula provides a link between stochastic processes and partial differential equations. It is used to derive the Black-Scholes partial differential equation from the stochastic processes for asset prices and money accounts. In general, if an asset follows a given stochastic process, the price of a derivative on that asset obeys a particular partial differential equation.

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21 views2 pages

Appendix I - Feynman Kac Formula - 2016 - Computational Finance Using C and C

The Feynman-Kac formula provides a link between stochastic processes and partial differential equations. It is used to derive the Black-Scholes partial differential equation from the stochastic processes for asset prices and money accounts. In general, if an asset follows a given stochastic process, the price of a derivative on that asset obeys a particular partial differential equation.

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sandeep222
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© © All Rights Reserved
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Appendix I

Feynman–Kac Formula
I.1 SOME RESULTS
The Feynman–Kac formula provides a link between stochastic processes and
partial differential equations, which we will now illustrate.
In the risk-neutral measure, the equation followed by the asset price is
dS = r Sdt + σSdW (I.1.1)
and that of the money account
dB = Br dt. (I.1.2)
If f (S,t) is the value of a derivative, then using Ito’s lemma we have
∂f ∂f σ2 S2 ∂ 2 f ∂f
 
df = + rS + dt + σdW. (I.1.3)
∂t ∂S 2 ∂S 2 ∂S

Since f is a tradable, we know that the process ( f /B) must be a martingale in


the risk-neutral measure and therefore have zero drift.
We will now evaluate d ( f /B) using the Ito quotient rule (see equation
(2.6.4))
          
X1 X1 dX1 dX2 dX2 dX2 dX2 dX1
d = − +E −E (I.1.4)
X2 X2 X1 X2 X2 X2 X2 X1
and rewrite equation (I.1.2) and equation (I.1.3) as
dX1 = µ̄1 dt + σ̄1 dW,
dX2 = X2 µ̄2 dt,

where
∂f ∂f σ2 S2 ∂2 f
     
X1 f
d =d , µ̄1 = + rS + ,
X2 B ∂t ∂S 2 ∂S 2
∂f
σ̄1 = σ , σ̄2 = r, X1 = f , X2 = B, µ̄2 = r.
∂S
Evaluating equation (I.1.4), we obtain

 
dX2 dX2  
E = E µ̄22 dt 2 → 0,
X2 X2
µ̄1 dt + σ1 dW X2 µ̄2 dt
     
dX1 dX2
E =E → 0,
X1 X2 X1 X2
Computational Finance Using C and C#: Derivatives and Valuation. DOI: 10.1016/B978-0-12-
803579-5.00025-5 353
Copyright © 2016 Elsevier Ltd. All rights reserved.
354 APPENDIX | I Feynman–Kac Formula

and therefore,
µ̄1 dt + σ̄1 dW X µ̄ dt
    
X1 X1
d = − 2 2
X2 X2 X1 X2
µ̄1 σ̄1
     
X1
= − µ̄ dt + dW
X2 X2 2 X2
σ̄1
 
1
= { µ̄ − X1 µ̄2 } dt + dW. (I.1.5)
X2 1 X2

Since (X1 /X2 ) is a martingale, the drift term in equation (I.1.5) is zero so
µ̄1 − X1 µ̄2 = 0. (I.1.6)
Therefore, substituting for µ̄1 , X1 and µ̄2 in equation (I.1.6), we obtain
∂f ∂f σ2 S2 ∂ 2 f
+ rS + −rf = 0 (I.1.7)
∂t ∂S 2 ∂S 2
or
∂f ∂f σ2 S2 ∂ 2 f
+ rS + = r f, (I.1.8)
∂t ∂S 2 ∂S 2
which is the Black–Scholes partial differential equation, which we derived in
Chapter 4.
In general, if an asset follows the process
dS = µ̄dt + σ̄dW, (I.1.9)
then the price of a derivative f (S,t) obeys the partial differential equation
∂f ∂f µ̄2 ∂ 2 f
+ µ̄ + =rf (I.1.10)
∂t ∂S 2 ∂S 2
or
∂ ∂ µ̄2 ∂ 2
 
+ µ̄ + f = r f. (I.1.11)
∂t ∂S 2 ∂S 2

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