This report represents the analysis and solution of example 3.

3 provided
in [1].

Introduction
Any endeavor for calculating the approximated price of some financial prod-
ucts, for example bonds and options, that begin with establishment of some
dynamic process which is followed by the asset. It is assumed that with the
assumptions, any underlying stock with the price denoted by S, it follows
log normal process
dS = µSdt + σSdX (1)
dX in√ Eq. 1 represents an increment in a Wiener process so that dX ≈
N (0, dt). Similarly, when short term interest rate denoted by r, it follows
the following procedure:
dr = u(r, t)dt + w(r, t)dX (2)
price for zero coupon bond V (r, t) with expiry date given in time t = T , it
satisfies the PDE given by:

∂V w(r, t)2 ∂ 2 V
∂V
+ + u(r, t) − λ(r, t)w(r, t) − rV = 0 (3)
∂t 2 ∂r2 ∂r
subject to V (r, T ) = 1, and where λ(r, t) is the market price of risk.
To understand the probabilistic properties posed by the random walks
referred by Eq. 2 and Eq.3 which we write in general as
dx = A(x, t)dt + B(x, t)dX (4)
it is necessary to find transition density functions (TDFs), p(x, t; y, t0 ), of the
underlying process. This density function p(x, t; y, t0 ) is defined by

Z b
0
Pr (a < x < b at time t | x at time t) = p(x, t; t, t0 )dy (5)
a

The variables x and t can be thought of as the current variables and y and
t0 as the future variables.

Function A = A(x)
We can let A(x) in Eq. 4 vary in A = A(x) = µx such that,
γ 1
R A(x)
( )dx
z = x− 2 e c2 x2γ p (6)

1
 2γ 1 c2 γ 2 2y−2 c2 γ 2γ−2
Q = −A0 + A − 2 2 A2 + x − x (7)
x cxγ 4 2
Q = ( xk12 ) + k2 . For the case corresponding to Eq. 6, we require that A satisfy
1

2γ 1
A0 − A + 2 2 A2 = mx2y−2 + n (8)
x cxγ
where,
c2 γ 2 c2 γ
m = −k1 c2 (1 − y)2 + − (9)
4 2
and
n = −k2 (10)
In general, for γ ≥ 0, y 6= 1, we can write,
1 1
0 x 2 y 2 −2γ  k2 0  x2−2γ + y 2−2γ 0
p(x, t; y, t ) = 2 0
exp (t − t) exp 2 2
(t − t)
c |1 − γ|(t − t)) 2 c (1 − γ)
1−γ 1−γ Z y Z x
x y 1 A(x) A(x)
× Iv 2 2 0
exp 2 2γ
dx 2γ
dx − (11)
c (1 − γ) (t − t)) c x x

Discussion on examples
A few examples are used to illustrate the procedure proposed in this paper [1].
These examples are discussed here.

Example 3.1
This example is a numerical illustration of proposed method.

Example 3.3
Find transition density functions (TDFs)
I use example 3-3 pages 11

use A form pages 8 (3.16a)

USE Function P (3.27) Form Pages 11

σ 2 S 2γ
Vt + VXX + rSVX − rV = 0 (12)
2
2
 σ 2 S 2γ
Pt + PXX + rSPX = 0 (13)
2

β = σX Γ (14)

A = rx (15)

1 2 1 2 2
A0 + A = r + r x (16)
σ2 σ2

A = µx (17)
1 2 2
µ+ µ x = mx−2 + n (18)
c2
2
assume, β = µc2 , α = 0 and  = µ. so o function form pages 11 is best p i
can use for different γ

Find transition density functions (TDFs)

Part-A
We are interested in the solution for equation 3.16 for the case when {A(x) =
µx} . This corresponds to special values of the parameters. There is in
general a different solution for the density function corresponding to each
parameter. For A(x) = µx , the density function can be solved to give

0
    
1 1 µ x2−2γ e2(γ−1)µ(t−t ) +y 2−2γ 0
(γ−1)µ(t−t ) x1−γ y 1−γ
2µx y
2 2
−2γ
exp 0
c2 (γ−1)(e2(γ−1)µ(t−t ) −1)
I 1 (1−γ) − c2 2e−1+e2(γ−1)µ(t−t 0)
0
2 ( )(γ−1)
p(x, t; y, t ) = 2(γ−1)µ(t−t0 )
c2 (e − 1)
(19)

Part-B
p(x, t; y, t0 ) is plotted below for the case when γ = 0, 1/2, 1, 3/2 as a function
of y with x = 20, t = 0.1, t0 = 0, c = 0.1 and µ = 1/2.

3
1 Find Price for Call option
The price of call option is given by the equation

Z100
−r(T −t)
C(x, t) = e (y − K)p(x, t; y, t0 )dy (20)
K=20

S r c γ Call

15 0.05 0.1 0 1.02116

17 0.04 0.2 0.5 1.02116
1
T = 12
20 0.03 0.3 1 0.995842
22 0.02 0.4 1.5 -1.73346
25 0.01 0.5 0 1.02116

15 0.05 0.1 0 1.01691

17 0.04 0.2 0.5 1.01691
2
T = 12
20 0.03 0.3 1 0.991701
22 0.02 0.4 1.5 -1.72625
25 0.01 0.5 0 1.01691

15 0.05 0.1 0 1.01268

17 0.04 0.2 0.5 1.01268
3
T = 12
20 0.03 0.3 1 0.987578
22 0.02 0.4 1.5 -1.71907
25 0.01 0.5 0 1.01268

2 Find Price for Put option

ZK
P (x, t) = e−r(T −t) (K − y)p(x, t; y, t0 )dy (21)
0

4
 S r c γ Put

15 0.05 0.1 0 0
17 0.04 0.2 0.5 0
1
T = 12
20 0.03 0.3 1 0.995842
22 0.02 0.4 1.5 -0.712301
25 0.01 0.5 0 0

15 0.05 0.1 0 0
17 0.04 0.2 0.5 0
2
T = 12
20 0.03 0.3 1 0.991701
22 0.02 0.4 1.5 -0.709339
25 0.01 0.5 0 0

15 0.05 0.1 0 0
17 0.04 0.2 0.5 0
3
T = 12
20 0.03 0.3 1 0.987578
22 0.02 0.4 1.5 -0.706389
25 0.01 0.5 0 0

3 Proof of Equation 3.19

To prove equation 3.19, we have to first integrate
R A(x)
dx = xµx
R
x2γ 2γ dx
x2−2γ (22)
= µ 2(1−γ)
This will give
0
 
µx2−2γ
0 γ −
c2 2(1−γ)
1 1−γ t − t
p(x, t; y, t ) = x e 2 z x , (23)
c(1 − γ) 2
Now we must plug in the values α = 0 and β = µ2 /c2 and  = µ(1 − 2γ),
which means that

γ(γ − 2)
k1 = , k2 = −(1 − γ)2 µ2 , k3 = −µ(1 − 2γ) (24)
4(1 − γ)2

5
 When these expressions are inserted for
√
k2 2
x
√
tan(2 k2 y)+k3 y
√ !
e 2 x tan(2 k2 y)
z(x, y) = p √ u √
, √ (25)
cos(2 k2 y) cos 2 k2 y 2 k2
Then it gives that
0
    
1 1 µ x2−2γ e2(γ−1)µ(t−t ) +y 2−2γ 0
(γ−1)µ(t−t ) x1−γ y 1−γ
2µx y2 2
−2γ
exp 0
c2 (γ−1)(e2(γ−1)µ(t−t ) −1)
I 1 (1−γ) − c2 2e−1+e2(γ−1)µ(t−t 0)
0
2 ( )(γ−1)
p(x, t; y, t ) = 2(γ−1)µ(t−t0 )
c2 (e − 1)
(26)

References
[1] J. Goard, “Fundamental solutions to kolmogorov equations via reduction
to canonical form,” Advances in Decision Sciences, vol. 2006, 2006.