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1

The Arithmetic Average Case


of Asian Options:
Reducing the PDE to the
Black-Scholes Equation
Solomon M. Antoniou
SKEMSYS
Scientific Knowledge Engineering
and Management Systems
37 oliatsou Street, Corinthos 20100, Greece
solomon_antoniou@yahoo.com
Abstract
We consider the path-dependent contingent claims where the underlying asset
follows an arithmetic average process. Considering the no-arbitrage PDE of these
claims, we first determine the underlying Lie Point Symmetries. After
determination of the invariants, we transform the PDE to the Black-Scholes (BS)
equation. We then transform the BS equation into the heat equation and we
provide some general solutions to that equation. This procedure appears for the
first time in the finance literature.
Keywords: Path-Dependent Options, Asian Options, Arithmetic Average Path-
Dependent Contingent Claims, Lie Symmetries, Exact Solutions.
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1. Introduction
A path-dependent option is an option whose payoff depends on the past history of
the underlying asset. In other words these options have payoffs that do not depend
on the assets value at expiry. Two very common examples of path-dependent
options are Asian options and lookback options.
The terminal payoff of an Asian option depends on the type of averaging of the
underlying asset price over the whole period of the options lifetime. According to
the way of taking average, we distinguish two classes of Asian options: arithmetic
and geometric options.
A lookback option is another type of path-dependent option, whose payoff
depends on the maximum or minimum of the asset price during the lifetime of the
option.
The valuation of path-dependent (Asian) European options is a difficult problem
in mathematical finance. There are only some simple cases where the price of
path-dependent contingent claims can be obtained in closed-form (refs. [1]-[8]).
If the underlying asset price follows a lognormal stochastic process, then its
geometric average has a lognormal probability density and in this case there is a
closed-form solution (ref. [5]). This is not however the case by considering
arithmetic average. In this case there is no closed-form solution. However in both
cases there are some numerical procedures available (ref. [8]).
It is the purpose of this article to provide a closed-form general solution for the
arithmetic path-dependent options.
The paper is organized as follows: In Section 2 we consider the general problem of
pricing the path-dependent contingent claims. In Section 3 we consider the Lie
Point Symmetries of the Partial Differential Equation (equation (3.1)) for the path-
dependent arithmetic average options. Full details of the calculation are provided
in Appendix A. In Section 4, considering two invariants of the PDE, we convert
3
the equation into the Black-Scholes equation. In section 5, we transform the BS
equation to the heat equation. We then find the general solution of our PDE
(Theorem 3). In section 6 we provide some solutions to the heat equation.
Because of the complexity of the calculations, we have included a great deal of
calculation details, supplemented by many Appendices.
2. Path-Dependent Contingent Claims
Suppose that an option pays off at expiration time T an amount that is a function
of the path taken by the asset between time zero and T. This path-dependent
quantity can be represented by an integral of some function of the asset over the
time period T t 0 :

T
0
t d ) t , S ( f ) T ( A (2.1)
where ) t , S ( f is a suitable function. Therefore, for every t, T t 0 , we have

t
0
t d ) t , S ( f ) t ( A (2.2)
or, in differential form,
dt ) t , S ( f dA (2.3)
We have thus introduced a new state variable A, which will later appear in our
PDE.
We are now going to derive the PDE of pricing of the path-dependent option. To
value the contract, we consider the function ) t , A , S ( V and set up a portfolio
containing one of the path-dependent options and a number A of the underlying
asset:
S A ) t , A , S ( V H (2.4)
The change in the value of this portfolio is given by, according to Its formula, by
dS A
S
V
dA
A
V
dt
S
V
S o
2
1
t
V
H d
2
2
2 2

,
_

,
_

(2.5)
4
Choosing
S
V
A

(2.6)
to hedge the risk and using (2.3), we find that
dt
A
V
) t , S ( f
S
V
S o
2
1
t
V
H d
2
2
2 2

,
_

(2.7)
This change is risk-free and thus earns the risk-free rate of interest r,
dt H r H d (2.8)
leading to the pricing equation
0 V r
S
V
S r
A
V
) t , S ( f
S
V
S o
2
1
t
V
2
2
2 2

(2.9)
combining (2.7), (2.8) and (2.4), where A in (2.4) has been substituted by (2.6)
for the value of A.
The previous PDE is solved by imposing the condition
) A , S ( O ) T , A , S ( V (2.10)
where T is the expiration time.
If A is considered to be an arithmetic average state variable,

t
0
t d ) t ( S A (2.11)
then PDE (2.9) becomes
0 V r
S
V
S r
A
V
S
S
V
S o
2
1
t
V
2
2
2 2

(2.12)
If A is considered to be a geometric average state variable,

t
0
t d ) t ( S ln A (2.13)
then PDE (2.9) becomes
5
0 V r
S
V
S r
A
V
) S (ln
S
V
S o
2
1
t
V
2
2
2 2

(2.14)
We list below the payoff types we have to consider along with PDEs (2.12) and
(2.14).
For average strike call, we have the payoff ) A , S ( O
) 0 , A S ( max (2.15)
For average strike put, we have the payoff
) 0 , S A ( max (2.16)
For average rate call, we have the payoff
) 0 , E A ( max (2.17)
For average rate put, we have the payoff
) 0 , A E ( max (2.18)
where E is the strike price.
This is an introduction to the path-dependent options. Details can be found in
Wilmotts 3-volume set on Quantitative Finance (ref. [3]).
3. Lie Symmetries of the Partial Differential Equation
The technique of Lie Symmetries was introduced by S. Lie [11]-[12] and is best
described in refs [13]-[28]. This technique was for the first time used in partial
differential equations of Finance by Ibragimov and Gazizov [29]. The same
technique was also used by the author in solving the Bensoussan-Crouhy-Galai
equation [30] and the HJB equation for a portfolio selection problem [31]. There is
however a growing lists of papers in applying this method to Finance. For a non
complete set of references, see [29]-[40].
We consider the PDE (2.12)
0 V r
A
V
S
S
V
S r
S
V
S o
2
1
t
V
2
2
2 2

(3.1)
6
We shall determine the Lie Point Symmetries of the previous equation.
We follow closely Olver (ref. [15]).
Let ) V , t , A , S ( A
) 2 (
be defined by
V r
A
V
S
S
V
S r
S
V
S o
2
1
t
V
) V , t , A , S ( A
2
2
2 2 ) 2 (

(3.2)
We introduce the vector field X (the generator of the symmetries) by

+

A
) V , t , A , S (
S
) V , t , A , S ( X
2 1


V
) V , t , A , S (
t
) V , t , A , S (
3

+ (3.3)
We calculate in Appendix A the coefficients
3 2 1
, , and and we find that
the Lie algebra of the infinitesimal transformations of the original equation (3.1)
is spanned by the five vectors

t
X
1

(3.4)

A
X
2

(3.5)
A
A
S
S X
3

(3.6)
V
V ) A r S (
o
2
A
A
S
AS 2 X
2
2
4

(3.7)

V
V X
5

(3.8)
and the infinite dimensional sub-algebra

V
) t , A , S ( X

(3.9)
where ) t , A , S ( is an arbitrary solution of the original PDE (3.1).
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4. Reduction of the equation to the BS equation
We shall now try to transform the pricing differential equation into another by
reducing the number of independent variables. We shall retain the time variable
and try to find a combination of the other two variables S and A. The best
candidate for this job is the generator
4
X given by (3.7).
We state and prove the following Theorem:
Theorem 1. Any solution of the partial differential equation
0 V r
A
V
S
S
V
S r
S
V
S o
2
1
t
V
2
2
2 2

can be expressed into the form


,
_


A
S
b exp ) t , x ( u A ) t , A , S ( V
n
(4.1)
where the function ) t , x ( u satisfies the Black-Scholes equation
0 u r u x r u x o
2
1
u
x xx
2 2
t
+ + (4.2)
with
2
A
S
x , b r n and
2
o
2
b .
Proof. Considering the generator
4
X , we can determine two invariants of the
PDE. For this purpose we have to solve the following system
V ) A r S (
dV
2
o
A
dA
AS 2
dS
2
2

(4.3)
The differential equation
2
A
dA
AS 2
dS
is equivalent to
A
dA
2
S
dS
, which can be
integrated to give
1
2
C
A
S
from which we can obtain our first invariant x:

2
A
S
x (4.4)
8
The second differential equation
V ) A r S (
dV
2
o
A
dA
2
2


can be written as (since
2
A x S )
V
dV
dA
A
A r A x
b
2
2

,
or
V
dV
dA
A
r
x b

,
_


where
2
o
2
b . By integration of this equation we find
V ln C ) A ln r A x ( b
2
+
from which there follows that
A x b b r
e A C V

, where C is a constant.
Therefore another invariant of the PDE is the function ) t , x ( u , related to ) t , A , S ( V
by

,
_

A
S
b exp ) t , x ( u A ) t , A , S ( V
n
(4.5)
with
2
o
r 2
b r n .
Upon substitution of ) t , A , S ( V given by (4.5) into equation (3.1), we find that the
function ) t , x ( u satisfies the BS equation
0 u r u x r u x o
2
1
u
x xx
2 2
t
+ + (4.6)
The proof is in Appendix B.
5. Transformation of the BS equation to the heat equation.
Under the substitution
9
x ln z (5.1)
and taking into account that

z zz xx
2
u u u x

z x
u u x
the BS equation (4.6) takes the form
0 u r u p u o
2
1
u
z zz
2
t
+ + (5.2)
where

2
o
2
1
r p (5.3)
Under the substitution
t T t (5.4)
where T is the expiry time, equation (5.2) becomes
u r u p u o
2
1
u
z zz
2
t
+ (5.5)
At this stage we use the following
Lemma. The equation
u c u b u a u
x xx
2
t
+ + (5.6)
under the substitution
) t b y x , t ( u e u
t c


(5.7)
can be converted into the heat equation

yy
2
t
u a u (5.8)
Proof. See Appendix C.
Using the above Lemma, equation (5.5) under the substitution
) y , t ( u e ) z , t ( u
t r
(5.9)
t p z y + (5.10)
10
is transformed into the equation

yy
2
t
u o
2
1
u (5.11)
Introducing further a new independent variable by

2
o
y (5.12)
equation (5.11) is transformed to the heat equation

t
w w (5.13)
where
) y , t ( u ) , t ( w w (5.14)
We thus arrive at the following
Theorem 2. The solution to the BS equation (4.6) is given by
) , t ( w e ) t , x ( u
t r
(5.15)
where
) t p x (ln
o
2
y
o
2
+ (5.16)
t T t (5.17)
and ) , t ( w satisfies the heat equation
t
w w .
Using Theorems 1 and 2, we get the following
Theorem 3. The differential equation (3.1) has the general solution

,
_



t r
A
S
b exp ) t , ( w A ) t , A , S ( V
m
(5.18)
where the function ) t , ( w satisfies the heat equation
t
w w .
The variables and t are defined by (5.16) and (5.17) respectively, while
b r m ,
2
o
2
b , p is given by (5.3) and x by (4.4).Therefore equation (5.18)
can be written in full notation as
11

,
_

,
_

t r
A
S
o
2
exp ) t , ( w
A
1
) t , A , S ( V
2
o
r 2
2
where

1
]
1

,
_

,
_

t o
2
1
r
A
S
ln
o
2

2
2
What we need now is some solutions to the heat equation, which are not singular
at 0 t ( T t ). We come to this point next.
6. General solutions of the heat equation
The Lie algebra of the infinitesimal symmetries of the heat equation
t
w w is
produced by the six vector fields

X
1


t
t 2

X
4


t
X
2


w
w

t 2 X
5


w
w X
3


w
w ) t 2 (
t
t 4

t 4 X
2 2
6

and the infinite dimensional sub-algebra



w u
) t , ( u X
where ) t , ( u is an arbitrary solution of the heat equation (refs. [15], [37]).
6.1. The solution that is invariant with respect to the generator

w
2
t
2
3 6 2
w ) a t 2 ( ) 1 t 4 ( t 4 X a X X + + + + +
(a is a constant) is given by ([15], [37])

'

,
_

,
_

1 t 4
2
,
2
a
W K
1 t 4
2
,
2
a
W K
1 t 4
1
) t , ( w
2
2
2
1
4
2

,
_

+
+
) t 2 arctan(
2
a
1 t 4
t
exp
2
2
(6.1)
12
where ) z , a ( W is the parabolic cylindrical function of imaginary argument
(Appendix D).
Note. The solution given by Olver [15] (Example 3.17, p.208) contains some
misprints. We have repeated the calculations [28] and we have found the solution
given by (6.1).
6.2. The solution that is invariant with respect to the generator

w t 5 2
w t 2 X X +
is given by ([15], [37])

,
_

+ + + +
3
t 2
t exp } ) t ( Bi K ) t ( Ai K { ) t , ( w
3
2
2
2
1
(6.2)
where ) x ( Ai and ) x ( Bi are the Airy functions (Appendix E).
Both solutions (6.1) and (6.2) we have considered, are not singular for 0 t
( T t ). This is because we want to take into account the payoff conditions (2.15)-
(2.18) valid for T t ( 0 t ).
Appendix A. Lie Symmetry Analysis of the pricing PDE.
We consider the PDE (3.1) :
0 V r
A
V
S
S
V
S r
S
V
S o
2
1
t
V
2
2
2 2

(A.1)
We shall determine the Lie Point Symmetries of the previous equation.
We follow closely Olver (ref. [15]).
Let ) V , t , A , S ( A
) 2 (
be defined by
V r
A
V
S
S
V
S r
S
V
S o
2
1
t
V
) V , t , A , S ( A
2
2
2 2 ) 2 (

(A.2)
We introduce the vector field X (the generator of the symmetries)
by
13

+

t
) V , t , A , S (
A
) V , t , A , S (
S
) V , t , A , S ( X
3 2 1


V
) V , t , A , S (

+ (A.3)
The second prolongation is defined in our case by the equation

SS
SS
t
t
A
A
S
S ) 2 (
V

V
X X pr

+ (A.4)
The Lie point symmetries of the equation are determined by
0 )] V , t , A , S ( A [ X pr
) 2 ( ) 2 (
as long as 0 ) V , t , A , S ( A
) 2 (
.
We implement next the equation 0 )] V , t , A , S ( A [ X pr
) 2 ( ) 2 (
.We have
0 )] V , t , A , S ( A [ X pr
) 2 ( ) 2 (

0 V r V S V S r V S o
2
1
V X pr
A S SS
2 2
t
) 2 (

1
]
1

+ + +
+ + + + ) r ( ] V V r V S o [
A S SS
2
1
0 S o
2
1
) S ( ) S r (
SS 2 2 t A S
+ + + + (A.5)
We have the following expressions for the coefficients
S
,
A
,
t

and
SS

+
t S 3
2
S V 1 S S 1 V S
S
V V V ) (

A S V 2 t S V 3 A S 2
V V V V V
+
t A 3
2
A V 2 A A 2 V A
A
V V V ) (

t A V 3 S A V 1 S A 1
V V V V V
+
S t 1
2
t V 3 t t 3 V t
t
V V V ) (
t S V 1 t A V 2 A t 2
V V V V V
14
+ +
2
S SV 1 VV t SS 3 S SS 1 SV SS
SS
V ) 2 ( V V ) 2 (
+
SS S 1 V t
2
S VV 3
3
S
VV 1 t S SV 3
V ) 2 ( V V V V V 2

St S V 3 SS A V 2 SS S V 1 SA S 2
V V 2 V V V V 3 V 2

SS t V 3 SA S V 2 St S 3 S A SV 2
V V V V 2 V 2 V V 2

A SS 2 A
2
S VV 2
V V V
Using the previous expressions for
S
,
A
,
t
and
SS
we get from
the equation (A.5) that
+ + + r ] V V r V S o [
A S SS
2
1
+ +
A S 2 t S 3
2
S V 1 S S 1 V S
V V V V ) ( { S r
+ } V V V V
A S V 2 t S V 3
+ +
S A 1 t A 3
2
A V 2 A A 2 V A
V V V V ) ( { S
+ } V V V V
t A V 3 S A V 1
+ +
A t 2 S t 1
2
t V 3 t t 3 V t
V V V V ) (
+
t S V 1 t A V 2
V V V V
+ + +
2
S SV 1 VV t SS 3 S SS 1 SV SS
2 2
V ) 2 ( V V ) 2 ( { S o
2
1

+
SS S 1 V t
2
S VV 3
3
S
VV 1 t S SV 3
V ) 2 ( V V V V V 2

St S V 3 SS A V 2 SS S V 1 SA S 2
V V 2 V V V V 3 V 2

SS t V 3 SA S V 2 St S 3 S A SV 2
V V V V 2 V 2 V V 2
0 } V V V
A SS 2 A
2
S VV 2
(A.6)
We have now to take into account condition 0 ) V , t , A , S ( A
) 2 (
.
For this purpose we substitute
t
u by
15
V r V S V S r V S o
2
1
A S SS
2 2
+
into (A.6). We thus derive the equation
+ + + r ] V V r V S o [
A S SS
2
1
+ + + } V V V V V ) ( { S r
A S V 2 A S 2
2
S V 1 S S 1 V S

+

'

+ + V r V S V S r V S o
2
1
} V { S r
A S SS
2 2
S V 3 S 3

+ + + } V V V V V ) ( { S
S A V 1 S A 1
2
A V 2 A A 2 V A

+

'

+ + V r V S V S r V S o
2
1
} V { S
A S SS
2 2
A V 3 A 3

'

+ + + V r V S V S r V S o
2
1
) (
A S SS
2 2
t 3 V t

+

'

+
A t 2 S t 1
2
A S SS
2 2
V 3
V V V r V S V S r V S o
2
1

'

+ + V r V S V S r V S o
2
1
} V V {
A S SS
2 2
S V 1 A V 2
+ + + + } V ) 2 ( V ) 2 ( { S o
2
1
2
S SV 1 VV S SS 1 SV SS
2 2
+ } V V 2 { S o
2
1
2
S VV 3 S SV 3 SS 3
2 2
+

'

+ V r V S V S r V S o
2
1
A S SS
2 2
+ +
SA S 2 SS S 1 V
3
S
VV 1
2 2
V 2 V ) 2 ( V { S o
2
1

St S V 3 SS A V 2 SS S V 1
V V 2 V V V V 3
+ } V V 2 V 2 V V 2
SA S V 2 St S 3 S A SV 2
+

'

+ + V r V S V S r V S o
2
1
} V { S o
2
1
A S SS
2 2
SS V 3
2 2
0 } V V V { S o
2
1
A SS 2 A
2
S VV 2
2 2
+ (A.7)
16
Equate all the coefficients of the partial derivatives of the function V to zero. We
are then going to obtain a system of partial differential equations of the unknown
coefficients
3 2 1
, , and of the vector field (A.3). Before that, and just for the
economy of the calculations, we observe that we can get some simple expressions,
by first looking at the coefficients of the mixed partial derivatives.
In fact the coefficient of the derivative
SA
V is ) 2 ( S o
2
1
S 2
2 2
and that of
SA S
V V is ) 2 ( S o
2
1
V 2
2 2
which means that 0
S 2
and 0
V 2
.
Therefore the coefficient
2
does not depend either on S or V:
) t , A (
2 2
(A.8)
The coefficient of the derivative
St S
V V is ) 2 ( S o
2
1
V 3
2 2
and that of
St
V is
) 2 ( S o
2
1
S 3
2 2
which means that 0
V 3
and 0
S 3
. Therefore the
coefficient
3
does not depend neither on V nor on S:
) t , A (
3 3
(A.9)
Because of (A.8) and (A.9), equation (A.7) becomes
+ + + r ] V V r V S o [
A S SS
2
1
+ + + } V V ) ( { S r
2
S V 1 S S 1 V S

+ + + } V V V V ) ( { S
S A V 1 S A 1 A A 2 V A
+

'

+ + V r V S V S r V S o
2
1
) ( S
A S SS
2 2
A 3

'

+ + + V r V S V S r V S o
2
1
) (
A S SS
2 2
t 3 V t
+

'

+ + V r V S V S r V S o
2
1
) V ( V V
A S SS
2 2
S V 1 A t 2 S t 1
17
+ + + + } V ) 2 ( V ) 2 ( { S o
2
1
2
S SV 1 VV S SS 1 SV SS
2 2
0 } V V 3 V ) 2 ( V { S o
2
1
SS S V 1 SS S 1 V
3
S
VV 1
2 2
+ + (A.10)
The coefficient of
SS S
V V is the sum of the terms

,
_


2 2
V 1
S o
2
1
) ( and ) 3 ( S o
2
1
V 1
2 2

and therefore 0
V 1
, which means that
) t , A , S (
1 1
(A.11)
Therefore (A.10) becomes
+ + + r ] V V r V S o [
A S SS
2
1
+ + + + + } V V ) ( { S } V ) ( { S r
S A 1 A A 2 V A S S 1 V S

+

'

+ + V r V S V S r V S o
2
1
) ( S
A S SS
2 2
A 3

'

+ + + V r V S V S r V S o
2
1
) (
A S SS
2 2
t 3 V t
+ + + + } V V ) 2 ( { S o
2
1
V V
2
S VV S SS 1 SV SS
2 2
A t 2 S t 1
0 V ) 2 ( S o
2
1
SS S 1 V
2 2
+ (A.12)
From (A.12) we get the following coefficients, which have to be zero:
Coefficient of
2
S
V :
0 S o
2
1
VV
2 2
(A.13)
Coefficient of
A
V :
0 ) ( S S
t 2 1 A 2 t 3 A 3
2
+ + (A.14)
Coefficient of
SS
V :
18
0 S o
2
1
) 2 ( S o
2
1
S o
A 3
3 2
S 1 t 3
2 2
1
2
+ + (A.15)
Coefficient of
S
V :
+ + +
A 3
2
A 1 S 1 t 3 1
S r S ) ( S r r
0 ) 2 ( S o
2
1
t 1 SS 1 SV
2 2
+ (A.16)
Zero-th order coefficient
+ + + +
t A 3 A S
V S r S S r r
0 S o
2
1
V ) ( r
SS
2 2
t 3 V
+ + (A.17)
We have now to solve the system of PDEs (A.13)-(A.17).
From (A.13) we get 0
VV
and therefore is a linear function with respect to
V:
) t , A , S ( V ) t , A , S ( u + (A.18)
From (A.15) we get

A 3 t 3 1 S 1
S
2
1

2
1

S
1
+ (A.19)
which is a linear differential equation with unknown function
1
.
The solution of the previous differential equation is
) t , A ( 0 S S
2
1
) S ln S (
2
1

A 3
2
t 3 1
+ + (A.20)
where ) t , A ( 0 is a function to be determined.
From (A.14), using the expression (A.20) for the function
1
, we derive the
equation
+ + ) S ln S (
2
1
S
2
3
t 3
2
A 3

0 S )] t , A ( 0 [
t 2 A 2 t 3
+ + (A.21)
19
Since the previous equation should hold for every S, each one of the coefficients
has to be zero. Therefore we obtain the following four equations:
0
A 3
(A.22)
0
t 3
(A.23)
0 ) t , A ( 0
A 2 t 3
+ (A.24)
0
t 2
(A.25)
From the equations (A.22) and (A.23) and taking into account (A.9),we get that
3

is a constant:

1 3
a (A.26)
From equation (A.25) there follows that
2
is independent of the time t and so
) A ( f
2
(A.27)
Therefore equation (A.24) gives us
) A ( f ) t , A ( 0 (A.28)
The function
1
becomes, as follows from (A.20),
) A ( f S
1
(A.29)
From the above equation we get the following expressions to be used later on.
) A ( f
S 1
(A.30a)
0
SS 1
(A.30b)
) A ( f S
A 1
(A.30c)
0
t 1
(A.30d)
Equation (A.16), using the expressions (A.18)-(A.20), takes the form
0 u S o ) A ( f S ) A ( f S r ) A ( f S r
S
2 2 2
+
Solving the previous equation with respect to
S
u , we find
) A ( f u o
S
2
(A.31)
and therefore
20
) t , A ( p S ) A ( f u o
2
+ (A.32)
where ) t , A ( p is a function to be determined.
We also find from (A.31) that
0 u S
SS
2
(A.33)
an expression we shall need later on.
From (A.32) we also get
) t , A ( p u o
t t
2
(A.34)
and
) t , A ( p S ) A ( f u o
A A
2
+ (A.35)
From (A.17), using (A.18) we obtain the equation
+ + + + + + ) V u ( S ) V u ( S r ) V u ( r
A A S S
0 ) V u ( S o
2
1
V ) u ( r ) V u (
SS SS
2 2
t 3 t t
+ + + + + (A.36)
Equating the coefficients of V to zero, we get from the previous equation the
following two equations:
+ + +
A S
u S u S r u r
0 u S o
2
1
) u ( r u
SS
2 2
t 3 t
+ + + (A.37)
and
0 S o
2
1
S S r r
SS
2 2
t A S
+ + + + (A.38)
Equation (A.38) expresses the fact that the function introduced in (A.14) is a
solution of the original PDE.
Equation (A.37) can be expressed as

+ + + )} t , A ( p S ) A ( f {
o
1
S ) A ( f
o
1
S r
A
2 2

21
0 ) t , A ( p
o
1
t
2
+ (A.39)
The previous equation can be written in equivalent form
0 S ) A ( f S )} A ( f r ) t , A ( p { ) t , A ( p
2
A t
+ + + (A.40)
Since the previous equation should hold for any value of S, we get the following
equations:
0 ) A ( f (A.41)
0 ) A ( f r ) t , A ( p
A
+ (A.42)
0 ) t , A ( p
t
(A.43)
From (A.41) we conclude that ) A ( f is a second degree
polynomial with respect to A:

2
4 3 2
A a A a a ) A ( f + + (A.44)
From (A.43), we obtain that ) t , A ( p does not depend on t. Therefore
) A ( g ) t , A ( p (A.45)
and so equation (A.42) becomes, because of (A.45) and (A.44)
0 a 2 r ) A ( g
4
+
from which we determine the function ) A ( g :

5 4
a A a r 2 ) A ( g + (A.46)
Therefore

5 4
a A a r 2 ) t , A ( p + (A.47)
Le us collect now everything together.
We find from (A.29) and (A.44) that
) A a 2 a ( S
4 3 1
+ (A.48)
From (A.27) and (A.44) we find that

2
4 3 2 2
A a A a a + + (A.49)
We also have from (A.26)
22

1 3
a (A.50)
From (A.32), using (A.44) and (A.47) we find
) a A a r 2 S a 2 (
o
1
) t , A , S ( u
5 4 4
2
+ (A.51)
and so using (A.18),
) t , A , S ( V ) a A a r 2 S a 2 (
o
1
) t , A , S (
5 4 4
2
+ + (A.52)
Therefore the vector X, the generator of the symmetries, can be expressed as
+

+
S
) S A a 2 S a ( X
4 3

+

+ + +
t
a
A
) A a A a a (
1
2
4 3 2
V
) t , A , S ( V ) a A a r 2 S a 2 (
o
1
5 4 4
2

'

+ + +
The previous expression can be written as
+

,
_

A
A
S
S a
A
a
t
a X
3 2 1

+

,
_

+
V
V ) A r S (
o
2
A
A
S
AS 2 a
2
2
4

V
) t , A , S (
V
V
o
1
a
2
5

,
_

+ (A.53)
Therefore, we conclude from (A.53) that the Lie algebra of the infinitesimal
transformations of the original equation (3.1) is spanned by the five vectors given
by (3.4)-(3.8) and the infinite dimensional Lie sub-algebra with generator given by
(3.9).
Appendix B.
In this Appendix we transform the original PDE (3.1) to the BS equation.
23
Using the transformation (4.5), we can express the various partial derivatives of
the function ) t , A , S ( V in terms of the partial derivatives of the function ) t , x ( u .
We find that

,
_

A
S
b exp A u V
n
t t

,
_

+

A
S
b exp ) A u b A u ( V
1 n 2 n
x S

,
_

+ +

A
S
b exp ) A u b A u b 2 A u ( V
2 n 2 3 n
x
4 n
xx SS

,
_

+

A
S
b exp ) A S u b A u n A S u 2 ( V
2 n 1 n 3 n
x A
Substituting the above expressions into the original equation (3.1), we obtain
+ + + +

) A u b A u b 2 A u ( S o
2
1
u A
2 n 2 3 n
x
4 n
xx
2 2
t
n

+ + +

) A u b A u ( S r
1 n 2 n
x
+ +

) A S u b A u n A S u 2 ( S
2 n 1 n 3 n
x

0 A u r
n

The previous equation can be put into the form
+ +

xx
4 n 2 2
t
n
u ) A S ( o
2
1
u A
+
1
]
1

+ +

x
3 n 2 2 n 3 n 2 2
u ) A S ( 2 ) A S ( r ) A S ( b 2 o
2
1

+ + +

) A S ( n ) A S ( b r ) A S ( b o
2
1
1 n 1 n 2 n 2 2 2
| 0 u A r ) A S ( b
n 2 n 2


(B.1)
We now have to simplify the expressions appearing within the brackets of the
previous equation. We have
24
(I)
n 2 4 n 4 2 4 n 2
A x A ) A x ( A S

(II) +

) A S ( 2 ) A S ( r ) A S ( b 2 o
2
1
3 n 2 2 n 3 n 2 2
+
3 n 4 2 2 n 2 3 n 4 2
2
2
A ) A x ( 2 A ) xA ( r A ) A x (
o
2
2 o
2
1
n 1 n 2 n 1 n 2
A x r A x 2 A x r A x 2 +
+ +
(III) + +
n 2 n 2 1 n 1 n 2 n 2 2 2
A r ) A S ( b ) A S ( n ) A S ( b r ) A S ( b o
2
1
+ +
1 n 2
2
2 n 4 2
4
2
A ) A x (
o
2
r A ) A x (
o
4
o
2
1

,
_

+
n 2 n 4 2
2
1 n 2
2
A r A ) A x (
o
2
A ) xA (
o
r 2
+
+ + 1 n
2
2 n 2
2
A x
o
r 2
A x
o
2

n n 2 n 2
2
1 n
2
A r A r A x
o
2
A x
o
r 2

+ +
Substituting the previous expressions (I)-(III) into equation (B.1), we obtain the
equation
0 u r u x r u x o
2
1
u A
x xx
2 2
t
n

,
_

+ +
from which we get
0 u r u x r u x o
2
1
u
x xx
2 2
t
+ +
which is the well-known Black-Scholes (BS) equation.
Appendix C. In this Appendix we shall transform the equation
u c u b u a u
x xx
2
t
+ +
to the heat equation, where a, b, c are constants.
25
C1. Lie Symmetry Analysis of the equation
After performing a Lie symmetry analysis, we have found that the above equation
has the six symmetry generators (six vector fields)
t
X
1

(C.1)
u
u t c
a 4
b
x
a 4
b
t
t
x
x
2
1
X
2
2
2
2

,
_

,
_

,
_

(C.2)

2 x
a 8
1
t 2 x
a 4
b
t
t
x
t x X
2
2 2
2
3

u
u t
2
1
t c
a 4
b
2
2
2

,
_

1
1
]
1

(C.3)
x
X
4

(C.4)
u
u t
a 2
b
x
a 2
1
x
t X
2 2
5

,
_

(C.5)
u
u X
6

(C.6)
and the infinite dimensional sub-algebra
u
) t , x ( X

(C.7)
where ) t , x ( is an arbitrary solution of the original equation (ref. [37])
C.2. Transformation of the equation to the heat equation
We shall consider a linear combination of generators such as to convert the BS
equation to the heat equation. For this reason, we consider
u
u
x
1
t
1
X

(C.8)
where and are constants to be determined.
In order to determine the invariants corresponding to the symmetry (C.8), we
consider the system
26
u
du
1
dx

1
dt
(C.9)
From the equation
1
dx

1
dt
we get by integration x C t
1
+
or
1
C t v x + and hence one invariant of the equation is
t v x y (C.10)
From the equation
u
du
1
dt
we get by integration ) u C ln( t
2

or u C e
2
t
and hence another invariant is

t
e u u

(C.11)
Therefore

t
e u u (C.12)
Using (C.12) and (C.10) we find that

t
y t t
e ) u u v u ( u +

t
y x
e u u

t
yy xx
e u u
Therefore the equation u c u b u a u
x xx
2
t
+ + transforms to the equation
(divided by the factor
t
e )
u c u b u a u u v u
y yy
2
y t
+ + +
from which we get
u ) c ( u ) b v ( u a u
y yy
2
t
+ + + (C.13)
We determine now v and such as to become zero the coefficients
of
y
u and u:
0 b v +
27
0 c
Therefore we should have b v and c , and hence the two
invariants will be
t b x y + and u e u
t c


Therefore we arrive at the following
Lemma
The substitution
) bt y x , t ( u e u
t c


converts the equation u c u b u a u
x xx
2
t
+ + to the heat equation

yy
2
t
u a u
Appendix D. Webers Differential Equation
Abramowitz and Stegun ([41], 19.17) define as standard solutions of Webers
equation
y x
4
1
a y
2

,
_


the functions ) x , a ( W t where
) y G 2 y G (
a 2
) a a (cosh
) x , a ( W
2 3 1 1
4 / 1
t
with

,
_

+ a i
2
1
4
1
I G
1
kui

,
_

+ a i
2
1
4
3
I G
3

and
1
y ,
2
y are defined by
+

,
_

,
_

+ +
! 6
x
a
2
7
a
! 4
x
2
1
a
! 2
x
a 1 y
6
3
4
2
2
1
+

,
_

+ +

,
_

+ +
! 8
x
a
4
211
a 25 a
! 8
x
4
15
a 11 a
8
3 5
8
2 4
28
and
+

,
_

,
_

+ +
! 7
x
a
2
13
a
! 5
x
2
3
a
! 3
x
a x y
7
3
5
2
3
2
+

,
_

+ +

,
_

+ +
! 11
x
a
4
531
a 35 a
! 9
x
4
63
a 17 a
11
3 5
9
2 4
respectively.
In the previous expressions, the non-zero coefficients
n
a of
! n
x
n

are connected by

2 n n 2 n
a ) 1 n ( n
4
1
a a a
+

It is also worth noting that ) x , a ( W t can be expressed in terms of the Confluent
Hypergeometric functions ([41], 19.25)

'

,
_

t
2
3
1 4 / 3
x
4
1
, a
2
1
,
4
3
H
G
G
2 ) x , a ( W

,
_

t
2
1
3
x
4
1
, a
2
1
,
4
1
H x
G
G 2
where
+ +

) x i 2 ; 2 m 2 ; n i 1 m ( F e ) x , n , m ( H
1 1
x i
) x i 2 ; 2 m 2 ; n i 1 m ( M e
x i
+ +

Note. Webers equation can be obtained by separation of variables for the Laplace
equation in parabolic cylindrical coordinates (ref [42], Chapter 10).
Appendix E. The Airy equation
The differential equation of Airy
0 w z w
29
has as solutions the linearly independent solutions
) z ( Ai and ) z ( Bi
(Abramowitz and Stegun [41], 10.4).
These functions are defined by
) z ( g c ) z ( f c ) z ( Ai
2 1

)] z ( g c ) z ( f c [ 3 ) z ( Bi
2 1
+
where

! ) k 3 (
z
3
1
3 z
! 9
7 4 1
z
! 6
4 1
z
! 3
1
1 ) z ( f
k 3
k
0 k
k 9 6 3

,
_

+

+

+ +
and

! ) 1 k 3 (
z
3
2
3 z
! 10
8 5 2
z
! 7
5 2
z
! 4
2
z ) z ( g
1 k 3
k
0 k
k 10 7 4
+

,
_

+

+

+ +
+

respectively.
The constants
1
c and
2
c are given by

) 3 / 2 ( I 3
1
3
) 0 ( Bi
) 0 ( Ai c
3 / 2
1

and

) 3 / 1 ( I 3
1
3
) 0 ( i B
) 0 ( i A c
3 / 1
2


They also can be expressed in terms of Bessels functions of fractional order:
) ( K
3
z
a
1
) z ( Ai
3 / 1
([41], 10.4.14)
)} ( I ) ( I {
3
z
) z ( Bi
3 / 1 3 / 1
+

([41], 10.4.18)
where z z
3
2

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30
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