Optimal algebra and power series solution

of fractional Black-Scholes pricing model

∗
Hemanta Mandal, B. Bira
Department of Mathematics, SRM Institute of Science and Technology, Chennai-603203, India

Abstract
In the present article, we consider the fractional Black-scholes pricing model.
Using symmetry analysis, we derive the point symmetry involving some arbitrary
constants. Next, for each of the constant, we write the infinitesimal operators.
Further, under the full adjoint action, we construct and classify the finite dimen-
sional optimal system of Lie algebra. The similarity variables associated with
one of the optimal system is used to reduce the governing fractional partial dif-
ferential equations(FPDEs) to fractional ordinary differential equation(FODEs)
and subsequently, we obtain the power series solution. Finally, the correctness
of the method is given in its convergence analysis.

Keywords: Black-Scholes model; Symmetry analysis; Optimal system; Power series

method.

MSC codes: 35R11; 76M60; 30B10

1 Introduction
In the recent year, the study of fractional differential equations has attracted the at-
tention of many researchers and engineers due to their various applications in the
fields of physics, biology, engineering, signal processing, finance and fractional dynam-
ics [1, 2, 3]. The time-fractional Black–Scholes equation [4] is one of such model which
play important role in the price evolution of a European call or European put. Although
many researchers have studied this problem in different prospects but the symmetry
analysis for this model is very less understood and rare information is available in the
literature.
∗
Email address: bibekananda.b@ktr.srmuniv.ac.in

1
 2

The Lie symmetry analysis is one of the most powerful and systematic method to
study the such nonlinear fractional order differential equations. From the symmetry
group admitted by a given FPDEs, one can construct the group invariant solutions, for
example, the author in [9], studied invariance of the FPDEs under Lie group of trans-
formations. The application of Lie symmetry analysis to study the time fractional
KdV-type equation is found in [10], where as the complete group classifications, sym-
metry reduction and exact solution of the given FPDEs are obtained in [11, 12]). At
the same time, it very essential to classify Lie algebra up to some equivalence classes,
as the Lie algebra contain infinitely many subalgebra of the same dimension. For the
construction and classification of the Lie algebra the author refers [5, 6, 7, 8]. The main
advantage of Lie group analysis is that, it reduce the higher order nonlinear system to
lower order system under invariance condition which is comparatively easy to solve.
On the other hand, power series solution technique is an efficient technique to
find the solutions of complex differential equations like the differential equations of
fractional order through Lie group analysis. Very few research articles available in the
literature.
The structure of the work in this article is organized as follows, in section 2, symme-
try group of transformations for time fractional Black–Scholes equation are presented.
Section 3, deals with the classification of Lie algebra and the study of the optimal alge-
bra. The symmetry reduction of the given FPDE to the FODE is placed in section 4.
Next, derivation of the power series solution and it’s convergence are given in section
5. Finally some conclusions drawn in section 6.

2 Symmetry reduction of time-fractional black–scholes

equation
The well known black–scholes equation([4]) with time fractional derivatives, describing
governing the price evolution of a European call or European put under the Black–
Scholes model is considered as follows:
∂ αu
= uxx + (k − 1)ux − ku, (2.1)
∂tα
where u(x,t) is the price of the option as a function of stock price x and time t.
The parameter α is standing for the order of the fractional time derivative satisfying
0 < α < 1.
 3

The infinitesimal generators associated with (2.1) are [19]

∂
X1 = ,
∂t
∂ ∂ ∂ ∂ ∂ ∂
X2 = 2αx + 4t + 2αu − 4αxk − 2u − 4αx , (2.2)
∂x ∂t ∂u ∂u ∂u ∂u
∂
X3 = ,
∂x
∂
X4 = u .
∂u
The form of the above operators Xi , i = 1, 2, 3, 4 suggest their significance as X1
and X3 are the time and space translation respectively, whereas X2 is the scaling
transformation.

2.1 Calculating invariants

For the calculation of invariant, we compute the commutation relation between the
vector fields such that [vi , vj ] = vi vj − vj vi where i and j represent the row and column
respectively.

∗ X1 X2 X3 X4
X1 0 4X1 0 0
X2 −4X1 0 −2αX4 + α(k − 1)X5 0
X3 0 2αX4 − α(k − 1)X5 0 0
X4 0 0 0 0
∑4 ∑4
Substituting X = i=1 ai Xi and Y = j=1 bi Xi , We get

Adexp(ϵ) V = (a1 X1 + ... + a4 X4 − ϵ(β1 X1 + ...β4 X4 ) + O(ϵ2 )

with
β1 = b1 a2 − b2 a1 , β3 = 2αb3 a2 − 2αb2 a3 , β4 = α(k − 1)b2 a3 − α(k − 1)a2 b3 (2.3)
Taking derivative with respect to ϵ and setting ϵ = 0, From the coefficients of bi , We
obtain

∂ϕ
a2
=0
∂a1
∂ϕ ∂ϕ ∂ϕ
−a1 − 2αa4 + α(k − 1)a4 =0 (2.4)
∂a1 ∂a4 ∂a5
(k−1)
Solving (2.3), We obtain ϕ = F (a5 + 2
a4 ), where ϕ is an arbitrary function of its
arguments.
 4

2.2 Finding adjoint matrix

The adjoint representation is given by
1 2
Adexp(ϵw) v = v − ϵ[w, v] + ϵ [w, [w, v]] − ... (2.5)
2!
Ad X1 X2 X3 X4
X1 X1 X2 − X1 + e−4ϵ X1 X3 X4
X2 4ϵ
e X2 X2 e X3 − X4 + e−α(k−1)ϵ X4
2αϵ
X4
X3 X1 X2 − 2αϵX3 − α(k − 1)ϵX4 X3 X4
X4 X1 X2 X3 X4
Adjoint action of X1 is given by,
Adexp(ϵ1 X1 ) (a1 X1 + a2 X2 + a3 X3 + a4 X4 ) = (a1 − a2 4ϵ)X1 + a2 X2 + a3 X3 + a4 X4
So  
1 0 0 0
 
−4ϵ1 1 0 0
A1 =   (2.6)
 0 0 1 0
0 0 0 1
Similarly, A2 ,A3 and A4 are obtained as follows:
     
e4ϵ2 0 0 0 1 0 0 0 1 0 0 0
     
 0 1 0 0  0 1 −2αϵ3 α(k − 1)ϵ3  0 1 0 0
A2 =   , A3 =   , A4 =  
 0 0 e 2αϵ2
−α(k − 1)ϵ2  0 0 1 0  0 0 1 0
0 0 0 1 0 0 0 1 0 0 0 1

So the general adjoint transformation matrix A is obtained as

 
e4ϵ2 0 0 0
 
−4ϵ1 e4ϵ2 0 −2αϵ3 α(k − 1)ϵ3 
A = A1 A2 A3 A4 =   (2.7)
 0 0 e2αϵ2 −α(k − 1)ϵ2 
0 0 0 1

2.3 Classification of symmetry algebra

The adjoint transformation equations become

(a∗1 , a∗2 , a∗3 , a∗4 ) = (a1 , a2 , a3 , a4 )A (2.8)

case 1:a3 = 1
Selecting a representative element X = X3 and solving (2.4). We get the solution
a4
ϵ1 = 0, ϵ2 = e2α a3 , ϵ3 = , ϵ4 = 0 (2.9)
α(k − 1)a3
 5

Continuing in the similar fashion as in [20], We get the one dimensional optimal algebra
as follows,

X3 , X4 , X1 + X2 , X1 − X2 , X2 , X1 (2.10)

3 Symmetry reduction
Here, We calculate the power series solution of black–scholes equation corresponding
to the generator X1 + X2 . The associated characteristic equation is written as,
dx dt du
= = ,
2αx 4t + 1 2(α − 1)u

which yields the similarity variables

ξ = x(4t + 1)− 2 .
α−1 α
u = (4t + 1) 2 U (ξ), (3.11)

The use of the above similarity variables in the sense of modified Riemann Liouville
derivatives, the governing system of FPDE (2.1), can be reduce to a nonlinear system
of FODE, through the following theorem.

Theorem: The transformation (3.11) reduces (2.1) to the following nonlinear

FODE:
[ ]
α+1 α ∂ α−1
,1−α
1− − ξ I− 22 − uξξ + ku = 0
2 2 ∂ξ α

Where ∫ 1
1 1
Ica,b U (ξ) = (1 − s)b−1 sa U (ξs c )ds
Γ(b) 0

Proof: Considering the modified Riemann-Liouville fractional derivative to (2.1), We

get
[ ∫ t ]
∂αu ∂ 1 −α α−1 −α
= (t − s) z U (xz )ds
2 2
∂tα ∂t Γ(1 − α) 0

Let s = zt , and so tds = dz. Thus the equation (2.6), can be written as
[ α+1 ∫ 1 ]
∂αu ∂ t1− 2 −α α−1 − α
= (1 − s) τ 2 U (ξτ 2 )
∂tα ∂t Γ(1 − α) 0
∂ [ 1− α+1 α−1 ,1−α
]
= t 2 (I− 22 U )(ξ) (3.12)
∂t α
 6

one can obtain

∂ ∂ξ d α ∂
t =t =− ξ (3.13)
∂t ∂t dξ 2 ∂ξ
Using (2.8), the equation (2.7) can be written as
[ ]
∂ αu − α+1 α+1 α d α+1
,1−α
=t 2 (1 − − ξ )(I− 22
U )(ξ) .
∂tα 2 2 dξ α

Finally the reduced FODE is obtained as

[ ]
α+1 α d α+1
,1−α
(1 − − ξ )(I− 2 2
U )(ξ) + Uξξ − kU = 0 (3.14)
2 2 dξ α

4 Power series solution

In order to derive the explicit power series solution of (2.1), we consider (2.7) and
replaces the integral operator by the first term of the series of derivatives as below [21]
∑
∞
ξk
Ica,b U (ξ) = λk U (k) (ξ) , (4.15)
k=0
k!

where
∑
k
Γ(a + jc + 1)
λk = (kj )(−1)k−j . (4.16)
j=0
Γ(a + b + jc + 1)

Using (4.16) in (3.14), We get

K1 U − K2 ξU , + Uξξ − ku = 0 (4.17)
Γ(1+ α−1 ) α−1
α Γ(1+ 2 )
Where K1 = 2
Γ(1− α+1 )
, K2 = 2 Γ(2− α+1 )
2 2
Next, we seek a power series solution of equation (3.14) in the form given below
∑
∞
U (ξ) = an ξ n (4.18)
n=0

where the coefficients an to be determined recursively.

For that let us calculate the followings

′
∑
∞
U (ξ) = (n + 1)an+1 ξ n ,
n=0

′′
∑
∞
U (ξ) = (n + 1)(n + 2)an+2 ξ n (4.19)
n=0
 7

Substituting (4.18) and (4.19) into (4.17), we obtain

∑
∞ ∑
∞ ∑
∞ ∑
∞
K1 a n ξ n − K2 nan ξ n − (n + 1)(n + 2)an+2 ξ n + k an ξ n = 0
n=0 n=1 n=0 n=0

Comparing the coefficients of ξ for n = 0, we get

(K1 a0 + ka0 )
a3 = , (4.20)
(2)
Further, for n ≥ 1 one can have
1
an+2 = [K1 an − K2 nan + kan ], (4.21)
(n + 1)(n + 2)
Equation (4.18) can be rewritten as
∑
∞
(K1 a0 + ka0 ) 2
u(ξ) = a0 + a1 ξ + a2 ξ 2 + an+2 ξ n+2 = a0 + a1 ξ + ξ
n=1
2
1
+ [K1 an − K2 nan + kan ]ξ n+2
(n + 1)(n + 2)

4.1 Convergence analysis of power series solutions

In order to test the convergence of the power series solution (4.15), we define a new
series of the form
∑
∞
S = S(ξ) = sn ξ n , (4.22)
n=0

with si = |ai |(i = 0, 1) and it is enough to state and prove the following propositions.
Proposition: The series (4.22) is majorant series of (4.18).
proof: To show that the series (4.22) is majorant series of (4.18), it is enough to show
that |an | ≤ |sn | for n = 0 · · · ·· For that we consider the equation (4.18), we have the
following inequalities

|an+2 | ≤ M [|3an |] , (4.23)

for n = 0, 1, 2 · ··
Where
K1 nK2 k
M = M ax{ , , }
(n + 1)(n + 2) (n + 1)(n + 2) (n + 1)(n + 2)
Comparing equation (4.23) and equation (4.18) it can be shown that

|an | ≤ sn
 8

Therefore, equation (4.22) is majorant series of equation (4.18).

Proposition: The series (4.22) has positive radius of convergence in the interval (0, s0 ).
proof: In order to prove S = S(ξ) has positive radius of convergence, we write S(ξ)
in the following form
∑
∞
S(ξ) = s0 + s1 ξ + sn+2 ξ n+2
n=0
[ ]
∑
∞
= s0 + s1 ξ + s2 ξ 2 + 3sn ξ n+3
n=0
= s0 + s1 ξ + s2 ξ + M [3S(ξ)ξ 3 ],
2

Then considering the fractional equation with respect to the independent variable ξ,
we define

F (ξ, S) = S − s0 − s1 ξ − s2 ξ 2 − [3S(ξ)ξ 3 xi3 ], (4.24)

Now it is sufficient to show that F (ξ, S) is analytic in the neighborhood of (0, s0 ). From
the equation (4.24) it can be clearly observed that
′
F (0, s0 ) = 0, FS (0, s0 ) ̸= 0, (4.25)

implying that S(ξ) and Q(ξ) are analytic in the neighborhood of (0, s0 ). Proposi-
tion 1 and Proposition 2, together shows that (4.22) is majorant series of (4.18) and
has positive radius of convergence. Hence the power series (4.18) is convergent in a
neighborhood of the point (0, s0 ).

5 Conclusions
Finding all group invariant solutions of a differential equation can be a difficult task but
with the use of optimal algebra, this can be simplified to the classification of subgroups
of the original symmetry group. Discarding the trivial vectors, We took X1 + X2 as
our base generator to reduce the FPDE to FODE and subsequently finding its power
series solution giving the correctness of our method in its radius of convergence.

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