1

Pricing Asian Options:

the Geometric Average case

Solomon M. Antoniou
SKEMSYS
Scientific Knowledge Engineering
and Management Systems

37 oliatsou Street, Corinthos 20100, Greece
solomon_antoniou@yahoo.com

Dedicated to Gelly
Abstract
We consider the valuation of path-dependent contingent claims where the
underlying asset follows a geometric 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 with time-dependent coefficients. We then transform
the BS equation into the heat equation which is solved using Poissons formula
taking into account the payoff condition. We thus obtain a closed-form solution
for the pricing of asian options in the geometric average case. This procedure
appears for the first time in the finance literature.

Keywords: Path-Dependent Options, Asian Options, Geometric Average Path-
Dependent Contingent Claims, Lie Symmetries, Exact Solutions.


2
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 (Angus [3],
Barucci et al. [8], Bergman [9], Geman and Yor [23], Kemma and Vorst [33],
Rubinstein [42], Wilmott [49], Zhang [51]). However in both cases (geometric and
arithmetic average) there are some numerical procedures available (Barucci et al.
[8], Haug [25]).
In the case of arithmetic average there is no closed-form solution. However in one
of our previous paper (Antoniou [6]) we have been able to convert the PDE (2.12)
into the BS equation using symmetry methods.
If the underlying asset price follows a lognormal stochastic process, its geometric
average has a lognormal probability density and in this case there is a closed-form
solution (Angus [3]).
In this paper we provide a rigorous justification of the transformation which
converts the equation (2.14) into the BS equation, using symmetry methods. On
the other hand, we provide our own method of solution to the time-dependent BS
equation.
3
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 geometric average options. Full details of the calculation are provided
in Appendix A. In Section 4, considering one invariant of the PDE, we convert the
equation into the time-dependent Black-Scholes equation. In section 5, we
transform the BS equation to the heat equation. In section 6 we find a closed-form
solution, using Poissons formula and the payoff condition.
Because of the complexity of the calculations, we have included a great deal of
calculation details, supplemented by three 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 0 s s :

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

}
=
t
0
d ) , S ( f ) t ( (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
4
containing one of the path-dependent options and a number of the underlying
asset:
S ) t , A , S ( V = (2.4)
The change in the value of this portfolio is given by, according to Its formula, by
dS
S
V
dA
A
V
dt
t
V
S
2
1
t
V
d
2
2
2 2
|
|
.
|

\
|

c
c
+
c
c
+
|
|
.
|

\
|
c
c
+
c
c
= (2.5)
Choosing
S
V

c
c
= (2.6)
to hedge the risk and using (2.3), we find that
dt
A
V
) t , S ( f
t
V
S
2
1
t
V
d
2
2
2 2
|
|
.
|

\
|
c
c
+
c
c
+
c
c
= (2.7)
This change is risk-free and thus earns the risk-free rate of interest r,
dt r d = (2.8)
leading to the pricing equation
0 V r
S
V
S r
A
V
) t , S ( f
t
V
S
2
1
t
V
2
2
2 2
=
c
c
+
c
c
+
c
c
+
c
c
(2.9)
combining (2.7), (2.8) and (2.4), where in (2.4) has been substituted by (2.6)
for the value of .
The previous PDE is solved by imposing the condition
) A , S ( ) 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
d ) ( S (2.11)
then PDE (2.9) becomes
5
0 V r
S
V
S r
A
V
S
t
V
S
2
1
t
V
2
2
2 2
=
c
c
+
c
c
+
c
c
+
c
c
(2.12)
If A is considered to be a geometric average state variable,

}
=
t
0
d ) ( S ln (2.13)
then PDE (2.9) becomes
0 V r
S
V
S r
A
V
) S (ln
t
V
S
2
1
t
V
2
2
2 2
=
c
c
+
c
c
+
c
c
+
c
c
(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 ) T , A , S ( V
) 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 treatise (Wilmott [49], Vol.2 and Vol.3) on Quantitative Finance.

3. Lie Symmetries of the Partial Differential Equation

The technique of Lie Symmetries was introduced by S. Lie (Lie [36] and [37]) and
is best described in Anderson [2], Bluman and Anco [11], Bluman and Cole [12],
Bluman and Kumei [13], Campbell [17], Cantwell [18], Cohen [19], Dickson [20],
Dresner [21], Emanuel [22], Hydon [27], Ibragimov [28] and [29], Ince [31],
6
Olver [38], Ovsiannikov [39], Page [40], Schwarz [43], Steeb [46], Stephani [47]
and Wulfman [50]. This technique was for the first time used in partial
differential equations of Finance by Ibragimov and Gazizov [30]. The same
technique was also used by the author in solving the Bensoussan-Crouhy-Galai
equation (Antoniou [4]) , the HJB equation for a portfolio optimization problem
(Antoniou [5]) and the PDE reduction to the BS equation in the case of arithmetic
average asian options (Antoniou [6]).
There is however a growing lists of papers in applying this method to Finance. For
a non complete set of references, see Antoniou [7], Bordag [14], Bordag and
Chmakova [15], Bordag and Frey [16], Goard [24], Leach et al. [34], Pooe et al.
[41], Silberberg [42], Sinkala et al. [45].
Equation (2.12) of the arithmetic average case has been considered before
(Antoniou [6]) where it was reduced to the Black-Scholes equation using again
group-theoretic methods.
We now consider the PDE (2.14)
0 V r
S
V
S r
A
V
) S (ln
S
V
S
2
1
t
V
2
2
2 2
=
c
c
+
c
c
+
c
c
o +
c
c
(3.1)
We shall determine the Lie Point Symmetries of the previous equation.
We follow closely Olver [37].
Let ) V , t , A , S (
) 2 (
be defined by
0 V r
S
V
S r
A
V
) S (ln
t
V
S
2
1
t
V
2
2
2 2
=
c
c
+
c
c
+
c
c
+
c
c
(3.2)
We introduce the vector field X (the generator of the symmetries)
by

+
c
c
+
c
c
=
A
) V , t , A , S (
S
) V , t , A , S ( X
2 1


V
) V , t , A , S (
t
) V , t , A , S (
3
c
c
+
c
c
+ (3.3)
7
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 eight vectors

t
X
1
c
c
= (3.4)
+
c
c
+
c
c
+
c
c
=
A
A
2
3
t
t
S
) S ln S (
2
1
X
2


V
V t r t
8
) r 2 (
) S (ln
4
) r 2 (
2
2 2
2
2
c
c
(
(

+ (3.5)
+
c
c
+
c
c
+
c
c
+ =
t
t
A
A t 3
S
] A S 3 t ) S ln S [( X
2
3

+

+ +

+
2
2
2 2
2
2 2
2
t
8
) r 2 (
) S (ln

2
) S (ln t 2
4
) r 2 (

V
V A
2
) r 2 ( 3
t 2 t r
2
2
2
c
c
(
(

+ + (3.6)
A
X
4
c
c
= (3.7)
A
t
S
S X
5
c
c
+
c
c
= (3.8)
V
V t

) r 2 (
) S (ln

2
A
t
S
S t 2 X
2
2
2
2
6
c
c
(
(

+ +
c
c
+
c
c
= (3.9)
+
c
c
+
c
c
=
A
t
S
S t 3 X
3 2
7

V
V A

6
t
2
) r 2 ( 3
) S (ln t

6
2
2
2
2
2
c
c
(
(

+ + (3.10)
V
V X
8
c
c
= (3.11)
8
and the infinite dimensional sub-algebra

V
) t , A , S ( X

c
c
= (3.12)
where ) t , A , S ( is an arbitrary solution of the original PDE (3.1).

4. Reduction of the equation to the time-dependent
Black-Scholes equation
The invariant associated to the generator
5
X , given by (3.8) is
S ln t A y = (4.1)
This transformation, in a slightly different form, was used by Angus [3]. In our
case however we derived this transformation rigorously, using group-theoretic
arguments.
Considering the substitution
) t , y ( u ) t , A , S ( V = (4.2)
we can transform equation (3.1) to the equation
0 u r u t
2
1
u t r
2
1
u
yy
2 2
y
2
t
= +
|
.
|

\
|
+ (4.3)
Under the substitution
z ln y = (4.4)
we can transform (4.3) to the time-dependent BS equation
0 u r u z t
2
1
u z t
2
1
t r
2
1
u
zz
2 2 2
z
2 2 2
t
= o +
)
`

o +
|
.
|

\
|
o + (4.5)
Details are given in Appendix B.

5. Solution of the time-dependent Black-Scholes equation
The Black-Scholes equation
0 V ) t ( r
S
V
S ) t ( r
S
V
S ) t (
2
1
t
V
2
2
2 2
=
c
c
+
c
c
o +
c
c
(5.1)
9
with time-dependent coefficients, can, in complete analogy to the reasoning
developed in Appendix C, be converted into the heat equation. The reader is
advised to look at Appendix C before start reading this section.
Introducing the transformation
) S , t ( U e ) S , t ( V
) t ( f
= (5.1)
where

}
=
T
t
ds ) s ( r ) t ( f (5.2)
equation (5.1) takes the form
0
S
U
S ) t ( r
S
U
S ) t (
2
1
t
U
2
2
2 2
=
c
c
+
c
c
o +
c
c
(5.3)
We now consider the transformation

)
`

| = t
o + =
) t (
) t ( S ln x
(5.4)
where ) t ( o and ) t ( | are functions to be determined next.
Under this transformation, since
) t (
x
U
) t (
U
t
U
o'
c
c
+ |'
t c
c
=
c
c

and

x
U
S
U
S
c
c
=
c
c
,
x
U
x
U
S
U
S
2
2
2
2
2
c
c

c
c
=
c
c

equation (5.3) transforms into
0
x
U
) t ( r
x
U
x
U
) t (
2
1
) t (
x
U
) t (
U
2
2
2
=
c
c
+
|
|
.
|

\
|
c
c

c
c
o +
|
|
.
|

\
|
o'
c
c
+ |'
t c
c

which is equivalent to
0
x
U
) t ( r ) t (
2
1
) t (
x
U
) t (
2
1
) t (
U
2
2
2
2
=
c
c
|
.
|

\
|
+ o o' +
c
c
o + |'
t c
c
(5.5)
The choices
10
) t (
2
1
) t (
2
o = |' and 0 ) t ( r ) t (
2
1
) t (
2
= + o o' (5.6)
convert equation (5.3) into the heat equation

2
2
x
U U
c
c
=
t c
c
(5.7)
Therefore the required transformation, coming from (5.6), reads

}
o = o
T
t
2
ds ) s (
2
1
) t ( and
}
|
.
|

\
|
o = |
T
t
2
ds ) s (
2
1
) s ( r ) t ( (5.8)
where again T is the strike time.
Conclusion. The Black-Scholes equation
0 V ) t ( r
S
V
S ) t ( r
S
V
S ) t (
2
1
t
V
2
2
2 2
=
c
c
+
c
c
o +
c
c

with time-dependent coefficients, under the transformations
) S , t ( U e ) S , t ( V
) t ( f
= ,
}
=
T
t
ds ) s ( r ) t ( f
and

)
`

| = t
o + =
) t (
) t ( S ln x
,
}
o = o
T
t
2
ds ) s (
2
1
) t ( ,
}
|
.
|

\
|
o = |
T
t
2
ds ) s (
2
1
) s ( r ) t (
is converted into the heat equation
2
2
x
U U
c
c
=
t c
c
.
The above argument of solving the time-dependent Black-Scholes equation
appears for the first time in literature. For another method see Wilmott [49] (Vol.
2, section ).

6. The Option Pricing Formula.
We shall now derive the option pricing formula for the geometric average case of
Asian Options. We shall follow the following steps:
Step 1. We consider equation (4.5). We shall transform this equation into the Heat
Equation, along the lines of the previous section.
11
Under the transformation
) t , z ( U e ) t , z ( u
) t T ( r
= (6.1)
since

t
) t T ( r ) t T ( r
t
U e U e r u

+ =

z
) t T ( r
z
U e u

=

zz
) t T ( r
zz
U e u

=
equation (4.5) transforms into the equation
0 U z t
2
1
U z t
2
1
t r
2
1
U
zz
2 2 2
z
2 2 2
t
= o +
)
`

o +
|
.
|

\
|
o + (6.2)
Under the new transformation (see equation (C.8), Appendix C)

)
`

| = t
o + =
) t (
) t ( z ln x
(6.3)
since
) t ( U ) t ( U U
x t
o' + |' =
t


x z
U U z =

x xx zz
2
U U U z =
equation (6.2) takes on the form
0 U ) t ( t r
2
1
U t
2
1
U ) t (
x
2
xx
2 2
= |
.
|

\
|
o' +
|
.
|

\
|
o + o + |'
t
(6.4)
The choice

2 2
t
2
1
) t ( o = |' and t r
2
1
) t (
2
|
.
|

\
|
o = o' (6.5)
converts equation (6.4) into the heat equation

xx
U U =
t
(6.6)
Transformations (6.5) give us by integration in the interval ] T , t [ :
12
) t T (
6
1
s
2
1
) t (
3 3 2
T
t
2 2
o = o = |
}
(6.7)
and
) t T ( r
2
1
2
1
ds s r
2
1
) t (
2 2 2
T
t
2

|
.
|

\
|
o =
|
.
|

\
|
o = o
}
(6.8)
Step 2. We shall derive the option pricing formula under the boundary condition

+
|
.
|

\
|

|
.
|

\
|
= K
T
A
exp ) A , S ( f (6.9)
From the formula (4.1), we obtain
S ln
T
t
T
y
T
A
+ =
and then

|
.
|

\
|
+
=
|
.
|

\
|
T
S ln t y
exp
T
A
exp
Since z ln y = and ) t ( x z ln o = , with ) t ( o given by (6.8), we obtain

+
|
.
|

\
|

|
.
|

\
|
+ o
= K
T
S ln t ) t ( x
exp ) A , S ( f (6.10)
Using Poissons formula (see for example Tikhonov and Samarskii [48] or
Lebedev [35]) we have
dw e ) 0 , w ( U
2
1
) , x ( U
4
) w x (
2
t

+

}
t t
= t (6.11)
where ) 0 , x ( U can be derived from (6.10) for 0 = t , i.e. T t = :

)
`

|
.
|

\
|
+
= 0 , K
T
S ln T x
exp max ) 0 , x ( U (6.12)
Therefore
dw e 0 , K
T
S ln T w
exp max
2
1
) , x ( U
4
) w x (
2
t

+

}
)
`

|
.
|

\
|
+
t t
= t (6.13)
13
Under the substitution

t

=
2
x w
v
i.e.
v 2 x w t + = , dv 2 dw t = (6.14)
equation (6.13) takes on the form
dv 2 e 0 , K
T
S ln T v 2 x
exp max
2
1
) , x ( U
2
v
t

|
|
.
|

\
|
+ t +
t t
= t

+

}
(6.15)
We now have that
0 K
T
S ln T v 2 x
exp >
|
|
.
|

\
|
+ t +

if
e
t

|
.
|

\
|
>
2
x
S
K
ln T
v (6.16)
We thus get from (6.15) and (6.16)
dv e K
T
S ln T v 2 x
exp
1
) , x ( U
2
v
+
e
}

)

|
|
.
|

\
|
+ t +
t
= t
or
dv e K
1
dv e
1
) , x ( U
2
2
v
v
T
S ln T v 2 x

+
e
+
e

+ t +
} }
t

t
= t (6.17)
Using the identity
S ln
T
T
x
T
v v
T
S ln T v 2 x
2
2
2
+
t
+ +
|
.
|

\
|
t
=
+ t +

equation (6.17) becomes
dv e K
1
dv e
T
T x
exp S
1
) , x ( U
2
2
v T
v
2

+
e
+
e
|
.
|

\
| t

} }
t

|
.
|

\
| t +
t
= t (6.18)
14
The substitution

T
v s
t
=
converts equation (6.18) into the equation
dv e K
1
ds e
T
T x
exp S
1
) , x ( U
2 2
v s
2

+
e
+

} }
t
|
.
|

\
| t +

t
= t (6.19)
where

T 2
x
S
K
ln T
t

|
.
|

\
|

= (6.20)
At this stage we consider the complementary error function (for the special
functions used in the text see for example Abramowitz and Stegun [1], or Lebedev
[35]) defined by

t
=
}
+

d e
2
) x ( erfc
x
2

Therefore equation (6.19) gives us
) ( erfc K
2
1
) ( erfc
T
T x
exp S
2
1
) , x ( U
2
e |
.
|

\
| t +
= t (6.21)
There is a known identity
) x 2 ( ) x ( erfc
2
1
u = (6.22)
where ) x ( u is the cumulative function of the normal distribution ) 1 , 0 ( N with
mean 0 and variance 1, given by (see for example Abramowitz and Stegun [1])
du e
2
1
) x (
x
2
u
2
}

t
= u
Equation (6.21) then gives
) 2 ( K ) 2 (
T
T x
exp S ) , x ( U
2
e u u |
.
|

\
| t +
= t (6.23)
15
Let us now express everything in terms of the original variables.
Since ) t ( z ln x o + = and S ln t A y z ln = = , we finally have
) t ( S ln t A x o + = (6.24)
where ) t ( o is given by (6.8).
We also have that ) t ( | = t (see equations (6.3)) where ) t ( | is given by (6.7).
Introducing the notation
= 2 d
1
and e = 2 d
2
(6.25)
we find

T
) t ( 2
) t ( 2
) t (
S
K
ln T S ln t A
d
1
|
+
|
o +
|
.
|

\
|

= (6.26)

) t ( 2
) t (
S
K
ln T S ln t A
d
2
|
o +
|
.
|

\
|

= (6.27)
Therefore (6.23) becomes
) d ( K ) d (
T
T
) t ( S ln t A
exp S ) , x ( U
2 1
2
u u |
.
|

\
| t
+
o +
= t (6.28)
Collecting everything together, we obtain the following option pricing formula for
the Asian Options, for the geometric average case

)
`

u u |
.
|

\
| |
+
o +
=

) d ( K ) d (
T
) t (
T
) t ( S ln t A
exp S e ) t , A , S ( V
2 1
2
) t T ( r
(6.29)
Appendix A. Lie Symmetries of the Pricing Equation.
We consider the partial differential equation
0 V r
A
V
) S (ln
S
V
S r
S
V
S
2
1
t
V
2
2
2 2
=
c
c
+
c
c
+
c
c
o +
c
c

The Lie Symmetries of the previous equation are to be determined next.
Step 1. Let ) V , t , A , S (
) 2 (
be defined by
16
V r
A
V
) S (ln
S
V
S r
S
V
S
2
1
t
V
) V , t , A , S (
2
2
2 2 ) 2 (

c
c
+
c
c
+
c
c
+
c
c
=

Step 2. Introduce the vector field X (the generator of the symmetries) by

+
c
c
+
c
c
+
c
c
=
t
) V , t , A , S (
A
) V , t , A , S (
S
) V , t , A , S ( X
3 2 1


V
) V , t , A , S (
c
c
+ (A.1)
Step 3. The second prolongation is defined in our case by the equation

SS
SS
t
t
A
A
S
S ) 2 (
V V V V
X X pr
c
c
| +
c
c
| +
c
c
| +
c
c
| + =
Step 4. The Lie Symmetries of the equation are determined by the condition
0 )] V , t , A , S ( [ X pr
) 2 ( ) 2 (
= A as long as 0 V , t , A , S (
) 2 (
= A .
Implementation of the equation 0 )] V , t , A , S ( [ X pr
) 2 ( ) 2 (
= A :
We have
0 )] V , t , A , S ( [ X pr
) 2 ( ) 2 (
= A
0 V r V ) S (ln V S r V S
2
1
V X pr
A S SS
2 2
t
) 2 (
=
(

+ + o +
+ + + + ) r ( ] V
S
1
V r V S [
A S SS
2
1

0 S
2
1
) S (ln ) S r (
SS 2 2 t A S
= + + + +
Step 5. Calculation of
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

17
+ =
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
+ + =
2
S SV 1 VV t SS 3 S SS 1 SV SS
SS
V ) 2 ( V V ) 2 (
+
t
2
S VV 3
3
S
VV 1 t S SV 3
V V V V V 2
+
SS S V 1 SA S 2 SS S 1 V
V V 3 V 2 V ) 2 (

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

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

A SS 2 A
2
S VV 2
V V V
Step 6. Thus, using the previous expressions for
S
,
A
,
t
and
SS
from the
last equation of Step 4:
+ + + r ] V
S
1
V r V S [
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

+ +
t A 3
2
A V 2 A A 2 V A
V V V ) ( { ) S (ln
+ } V V V V V
t A V 3 S A V 1 S A 1

+ +
S t 1
2
t V 3 t t 3 V t
V V V ) (
+
t S V 1 t A V 2 A t 2
V 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
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
} V V V
A SS 2 A
2
S VV 2
(A.2)
18
Step 7. We now have to take into account the condition 0 V , t , A , S (
) 2 (
= A .
Substitute
t
u by V r V ) S (ln V S r V S
2
1
A S SS
2 2
+ into (A.2):
+ + + r ] V
S
1
V r V S [
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 (ln V S r V S
2
1
} V { S r
A S SS
2 2
S V 3 S 3
+ + + } V V V V V ) ( { ) S (ln
S A V 1 S A 1
2
A V 2 A A 2 V A
+
)
`

+ + V r V ) S (ln V S r V S
2
1
} V { ) S (ln
A S SS
2 2
A V 3 A 3

)
`

+ + + V r V ) S (ln V S r V S
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 (ln V S r V S
2
1

+
)
`

+ + V r V ) S (ln V S r V S
2
1
} V V {
A S SS
2 2
S V 1 A V 2

+ + + + } V ) 2 ( V ) 2 ( { S
2
1
2
S SV 1 VV S SS 1 SV SS
2 2

+ } V V 2 { S
2
1
2
S VV 3 S SV 3 SS 3
2 2

+
)
`

+ V r V ) S (ln V S r V S
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
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 (ln V S r V S
2
1
} V { S
2
1
A S SS
2 2
SS V 3
2 2

19
0 } V V V { S
2
1
A SS 2 A
2
S VV 2
2 2
= + (A.3)

Step 8. Equate all the coefficients of the partial derivatives of the function V to
zero. We are then going to have a system of partial differential equations. Before
that, and just for the economy of the calculations, we observe that we get some
simple expressions looking at the coefficients of the mixed partial derivatives.
In fact the coefficient of the derivative
SA
V is ) 2 ( S
2
1
S 2
2 2
and that of
SA S
V V is ) 2 ( S
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.4)
The coefficient of the derivative
St S
V V is ) 2 ( S
2
1
V 3
2 2
and that of
St
V is
) 2 ( S
2
1
S 3
2 2
which means that 0
V 3
= and 0
S 3
= . Therefore the
coefficient
3
does not depend either on V or S:
) t , A (
3 3
= (A.5)
Because of (A.4) and (A.5), equation (A.3) becomes
+ + + r ] V
S
1
V r V S [
A S SS
2
1

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

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

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

)
`

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

+
)
`

+ + V r V ) S (ln V S r V S
2
1
) V ( V V
A S SS
2 2
S V 1 A t 2 S t 1

20
+ + + + } V ) 2 ( V ) 2 ( { S
2
1
2
S SV 1 VV S SS 1 SV SS
2 2

0 } V V 3 V ) 2 ( V { S
2
1
SS S V 1 SS S 1 V
3
S
VV 1
2 2
= + + (A.6)
The coefficient of
SS S
V V is the sum of the terms

|
.
|

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

and therefore 0
V 1
= , which means that
) t , A , S (
1 1
= (A.7)
Therefore (A.6) becomes
+ + + r ] V
S
1
V r V S [
A S SS
2
1

} V V ) ( { ) S (ln } V ) ( { S r
S A 1 A A 2 V A S S 1 V S
+ + + +
)
`

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

)
`

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

} V V ) 2 ( { S
2
1
V V
2
S VV S SS 1 SV SS
2 2
A t 2 S t 1
+ + +
0 V ) 2 ( S
2
1
SS S 1 V
2 2
= + (A.8)
From (A.8) we get the following coefficients (which are equated to zero):
Coefficient of
2
S
V :
0 S
2
1
VV
2 2
= (A.9)
Coefficient of
A
V :
0 ) ( ) S (ln ) S (ln
S
1
t 2 2 t 3 3
2
1
= + + (A.10)
Coefficient of
SS
V :
0 ) ( ) S (ln S
2
1
) 2 ( S
2
1
S
A 3
2 2
S 1 t 3
2 2
1
2
= + + (A.11)
21
Coefficient of
S
V :
+ + +
A 3 A 1 S 1 t 3 1
) S (ln S r ) S (ln ) ( S r r
0 ) 2 ( S
2
1
t 1 SS 1 SV
2 2
= + (A.12)
Zero-th order coefficient
+ + + +
t 3 A S
V ) ( ) S (ln r ) S (ln S r r
0 S
2
1
V ) ( r
SS
2 2
t 3 V
= + + (A.13)
Step 9. We have now to solve the system of PDEs (A.9)-(A.13).
From (A.9) we get 0
VV
= and therefore is a linear function with respect to
V:
) t , A , S ( V ) t , A , S ( + = (A.14)
From (A.11) we get
) ( ) S (ln
2
1

2
1

S
1

A 3 t 3 1 S 1
+ =
which is a linear differential equation with unknown function
1
.
The solution of the previous differential equation is
) t , ( S ) ( ) S (ln S
4
1
) S ln S (
2
1

A 3
2
t 3 1
+ + = (A.15)
where ) t , ( is a function to be determined.
From (A.10), using (A.15), we get
0 ) t , ( ) S (ln
2
3
) S (ln
4
5
t 2 A 2 t 3
2
A 3
= +
(

+ (A.16)
Since the previous equation should hold for any value of S, we get from the
previous equation the following three equations:
0
A 3
= (A.17)
0
2
3
A 2 t 3
= (A.18)
22
0 ) t , (
t 2
= + (A.19)
Equation (A.17) expresses the fact that the function 0
3
= does not depend on
the variable A. Therefore, using also (A.5), we have that
) t ( f
3
= (A.20)
Using (A.18) and (A.20) we get
) t ( f
2
3

A 2
' =
and therefore
) t ( g A ) t ( f
2
3

2
+ ' = (A.21)
From (A.19), using (A.21) we get
) t ( g A ) t ( f
2
3
) t , ( ' + ' ' = (A.22)
Because of (A.17), we get another expression for the function
1
:
) t , ( S ) S ln S (
2
1

t 3 1
+ = (A.23)
From (A.23) we also get the following expressions for the partial derivatives of the
function
1
to be used later on.
) t , ( ) S ln 1 (
2
1

t 3 S 1
+ + = (A.24a)
t 3 SS 1

S
1
2
1
= (A.24b)
) t , ( S ) S ln S (
2
1

t tt 3 t 1
+ = (A.24c)
) t , ( S
A A 1
= (A.24d)
Equation (A.12), using the expressions (A.14), (A.23) and (A.24), takes the form
+
)
`

+
t 3 t 3
S r ) t , ( S ) S ln S (
2
1
r
23
+
)
`

+ + ) t , ( ) S ln S ( ) t , ( ) S ln 1 (
2
1
S r
A t 3

0 ) t , ( S ) S ln S (
2
1

S
1
2
1
2 S
2
1
t tt 3 t 3 S
2 2
=
(

+
Solving the previous equation with respect to
S
, we find
S
S ln
) t , A ( G
S
1
) t , A ( F
S
+ = (A.25)
where we have put
|
|
.
|

\
|
+

= ) t , (

r 2
4
1
) t , A ( F
t
2
t 3
2
2


|
|
.
|

\
|
+ = ) t , (

2
4
1
) t , A ( G

2
tt 3
2

Integrating (A.25) with respect to S, we find that
) t , ( ) S )(ln t , A ( G
2
1
) S )(ln t , A ( F ) t , A , S (
2
+ + = (A.26)
We also find from (A.25) that
) S ln 1 )( t , A ( G ) t , A ( F S
SS
2
+ = (A.27)
an expression we shall need later on.
From (A.26) we also get
) t , ( ) S )(ln t , A ( G
2
1
) S )(ln t , A ( F
t
2
t t t
+ + = (A.28)
and
) t , ( ) S )(ln t , A ( G
2
1
) S )(ln t , A ( F
A
2
A A A
+ + = (A.29)
From (A.13), using (A.14) we obtain the equation
+ + + + + + V ) ( ) S (ln r ) V ( ) S (ln ) V ( S r ) V ( r
3 A S S

0 ) V ( S
2
1
V ) ( r ) V (
SS SS
2 2
t 3 t t
= + + + + + (A.30)
24
Equating the coefficients of V to zero, we get from the previous equation the
following two equations:
+ o + o + o + o + o
A
) ( r ) ( ) S (ln r ) S (ln S r r
t 3 t 3 A S

0 S
2
1
SS
2 2
= o o + (A.31)
and
0 S
2
1
) S (ln S r r
SS
2 2
t S
= + + + + (A.32)
Equation (A.32) expresses the fact that the function introduced in (A.14) is a
solution of the original PDE.
We consider now equation (A.31). Using (A.26)-(A.29), this equation becomes
+ + )} S )(ln t , A ( G ) t , A ( F { r

)
`

+ + + ) t , ( ) S )(ln t , A ( G
2
1
) S )(ln t , A ( F ) S (ln
A
2
A A

+ + + + ) t , ( ) S )(ln t , A ( G
2
1
) S )(ln t , A ( F r
t
2
t t t 3

0 )} S ln 1 )( t , A ( G ) t , A ( F {
2
1
2
= + +
The previous equation can be expressed as
+
)
`

+ + ) t , ( G
2
1
) t , A ( r ) t , ( F ) r 2 (
2
1
2
t t 3
2

+
)
`

+ + + ) S (ln ) t , ( F ) t , A ( ) t , ( G ) r 2 (
2
1
t A
2

+
)
`

+ +
2
t A
) S (ln ) t , ( G
2
1
) t , A ( F
0 ) S (ln ) t , ( G
2
1
3
A
= + (A.33)
Since this equation should hold for any value of S, we obtain the following three
equations:
25
0 ) t , ( G
2
1
) t , A ( r ) t , ( F ) r 2 (
2
1
2
t t 3
2
= + + (A.34)
0 ) t , ( F ) t , A ( ) t , ( G ) r 2 (
2
1
t A
2
= + + (A.35)
0 ) t , ( G
2
1
) t , A ( F
t A
= + (A.36)
0 ) t , ( G
A
= (A.37)
Before proceeding to the solution of the above system of equations, it is instructive
to find some equivalent expressions for the functions ) t , A ( F and ) t , A ( G :
In fact, using (A.20) and (A.22), we find that

|
|
.
|

\
|
(

' ' + ' ' ' + '

= ) t ( g A ) t ( f
2
3

4
) t ( f

r 2
4
1
) t , A ( F
2 2
2
(A.38)
and
) t ( f

2
) t , A ( G
2
' ' = (A.39)
Equation (A.39) is compatible with (A.37). Equation (A.36), because of (A.38)
and (A.39), is equivalent to
0 ) t ( f

2
2
1
) t ( f
2
3

4
4
1
2 2
= ' ' ' +
(

' ' '

and therefore 0 ) t ( f = ' ' ' , which means that ) t ( f is a second degree polynomial
with respect to t:

2
3 2 1
t a t a a ) t ( f + + = (A.40)
and using (A.20),

2
3 2 1 3
t a t a a + + = (A.41)
Because of (A.40), the functions ) t , A ( F and ) t , A ( G become
) t ( g

1
) t a 2 a (
4
r 2
) t , A ( F
2
3 2
2
2
' ' + +

= (A.42)
26
and

3
2
a

4
) t , A ( G = (A.43)
respectively.
Equation (A.35), because of (A.42) and (A.43), becomes
) t ( g

1
a

r 2
2
3
) t , A (
2
3
2
2
A
' ' '

= (A.44)
Similarly, equation (A.34) gives us
+

' ' + +

= ) t ( g

1
) t a 2 a (
4
r 2
) r 2 (
2
1
) t , A (
2
3 2
2
2
2
t


3 3 2
a 2 ) t a 2 a ( r + + (A.45)
Equations (A.44) and (A.45) is a system of DEs with unknown functions ) t ( g and
) t , A ( . The compatibility condition
) t , A ( ) t , A (
tA At
=
taking into account (A.44) and (A.45), is equivalent to
0 ) t ( g

1
) iv (
2
=
from which there follows that ) t ( g is a third degree polynomial with respect to t:

3
7
2
6 5 4
t a t a t a a ) t ( g + + + = (A.46)
Therefore (A.44) and (A.45) become
} a 4 a ) r 2 {(
2
3
) t , A (
7 3
2
2
A
= (A.47)
and
+

+ + +

= ) t a 6 a 2 (

1
) t a 2 a (
4
r 2
) r 2 (
2
1
) t , A (
7 6
2
3 2
2
2
2
t


3 3 2
a 2 ) t a 2 a ( r + + (A.48)
respectively.
27
Integrating them with respect to A and t respectively, we obtain
) t ( h A } a 4 a ) r 2 {(
2
3
) t , A (
7 3
2
2
+ =
+ +

+ +

= ) t a 3 t a 2 (
2
r 2
) t a t a (
8
) r 2 (
) t , A (
2
7 6
2
2
2
3 2
2
2 2

) A ( k t a 2 ) t a t a ( r
3
2
3 2
+ + +
Comparing the two previous expressions we get the function ) t , A ( :
+ +

+ +

= ) t a 3 t a 2 (
2
r 2
) t a t a (
8
) r 2 (
) t , A (
2
7 6
2
2
2
3 2
2
2 2

+ + + t a 2 ) t a t a ( r
3
2
3 2


8 7 3
2
2
a A } a 4 a ) r 2 {(
2
3
+ + (A.49)
Using (A.46), the function ) t , A ( F becomes
) t a 3 a (

2
) t a 2 a (
4
r 2
) t , A ( F
7 6
2
3 2
2
2
+ + +

= (A.50)
From (A.21) we get

3
7
2
6 5 4 3 2 2
t a t a t a a A ) t a 2 a (
2
3
+ + + + + = (A.51)
From (A.22) we get the function ) t , ( :

2
7 6 5 3
t a 3 t a 2 a A a 3 ) t , ( + + + = (A.52)
From (A.23), using (A.41) and (A.52) we find
) t a 3 t a 2 a A a 3 ( S ) t a 2 a ( ) S ln S (
2
1

2
7 6 5 3 3 2 1
+ + + + + = (A.53)
From (A.26), using (A.50), (A.43) and (A.49) we find
+
|
|
.
|

\
|
+ + +

= ) S (ln ) t a 3 a (

2
) t a 2 a (
4
r 2
) t , A , S (
7 6
2
3 2
2
2

28
+ +

+ + ) t a t a (
8
) r 2 (
) S (ln a

2
2
3 2
2
2 2
2
3
2

+ + + +
o
o
+ t a 2 ) t a t a ( r ) t a 3 t a 2 (
2
r 2
3
2
3 2
2
7 6
2
2


8 7 3
2
2
a A } a 4 a ) r 2 {(
2
3
+ + (A.54)
Therefore we can now determine the function ) V , t , A , S ( introduced in (A.14):
+

|
|
.
|

\
|
+ + +

= ) S (ln ) t a 3 a (

2
) t a 2 a (
4
r 2
) V , t , A , S (
7 6
2
3 2
2
2

+ +

+ + ) t a t a (
8
) r 2 (
) S (ln a

2
2
3 2
2
2 2
2
3
2

+ + + +

+ t a 2 ) t a t a ( r ) t a 3 t a 2 (
2
r 2
3
2
3 2
2
7 6
2
2

) t , A , S ( V a A } a 4 a ) r 2 {(
2
3
8 7 3
2
2
+

+ + (A.55)
The vector X, the generator of the symmetries, can be expressed as
+
c
c
)
`

+ + + + + =
S
) t a 3 t a 2 a A a 3 ( S ) t a 2 a ( ) S ln S (
2
1
X
2
7 6 5 3 3 2

+
c
c
)
`

+ + + + + +
A
t a t a t a a A ) t a 2 a (
2
3
3
7
2
6 5 4 3 2

+
c
c
+ + +
t
) t a t a a (
2
3 2 1

+

|
|
.
|

\
|
+ + +

+ ) S (ln ) t a 3 a (

2
) t a 2 a (
4
r 2
7 6
2
3 2
2
2

+ +

+ + ) t a t a (
8
) r 2 (
) S (ln a

2
2
3 2
2
2 2
2
3
2

29
+ + + +

+ t a 2 ) t a t a ( r ) t a 3 t a 2 (
2
r 2
3
2
3 2
2
7 6
2
2


V
) t , A , S ( V a A } a 4 a ) r 2 {(
2
3
8 7 3
2
2
c
c

+
(
(

(
+ +
The previous expression can thus be written as
+
c
c
=
t
a X
1

+
c
c
+
c
c
+
c
c
+
A
A
2
3
t
t
S
) S ln S (
2
1
a
2

c
c
(
(

+
o
o
+
o
o
+
V
V t r t
8
) r 2 (
) S (ln
4
) r 2 (
2
2 2
2
2

+

c
c
+
c
c
+
c
c
+ +
t
t
A
A t 3
S
] A S 3 t ) S ln S [( a
2
3

+

o
o
+
o
+
o
o
+
2
2
2 2
2
2 2
2
t
8
) r 2 (
) S (ln
2
) S (ln t 2
4
) r 2 (

c
c
(
(

(
o
o
+ +
V
V A
2
) r 2 ( 3
t 2 t r
2
2
2

+
)
`

c
c
+
c
c
+
c
c
+
A
t
S
S a
A
a
5 4

+

c
c
(
(

+ +
c
c
+
c
c
+
V
V t

) r 2 (
) S (ln

2
A
t
S
S t 2 a
2
2
2
2
6

+

c
c
(
(

+ +
c
c
+
c
c
+
V
V A

6
t
2
) r 2 ( 3
) S (ln t

6
A
t
S
S t 3 a
2
2
2
2
2
3 2
7

V
) t , A , S (
V
V a
8
c
c
+
|
|
.
|

\
|
c
c
+
Therefore, the generators of the symmetries are:
30
t
X
1
c
c
=
+
c
c
+
c
c
+
c
c
=
A
A
2
3
t
t
S
) S ln S (
2
1
X
2


V
V t r t
8
) r 2 (
) S (ln
4
) r 2 (
2
2 2
2
2
c
c
(
(

+
+
c
c
+
c
c
+
c
c
+ =
t
t
A
A t 3
S
] A S 3 t ) S ln S [( X
2
3

+

+ +

+
2
2
2 2
2
2 2
2
t
8
) r 2 (
) S (ln

2
) S (ln t 2
4
) r 2 (


V
V A
2
) r 2 ( 3
t 2 t r
2
2
2
c
c
(
(

+ +
A
X
4
c
c
=
A
t
S
S X
5
c
c
+
c
c
=
V
V t

) r 2 (
) S (ln

2
A
t
S
S t 2 X
2
2
2
2
6
c
c
(
(

+ +
c
c
+
c
c
=

+
c
c
+
c
c
=
A
t
S
S t 3 X
3 2
7

V
V A

6
t
2
) r 2 ( 3
) S (ln t

6
2
2
2
2
2
c
c
(
(

+ +
V
V X
8
c
c
=
V
) t , A , S ( X

c
c
=
31
Note: The generators listed above can also provide some invariants which in turn
can be used to determine general solutions to the nonlinear equation (3.1).
Therefore the Lie symmetry analysis has a value on its own.
Appendix B. Reduction of equation (3.1) to the
time-dependent BS-equation.
We consider the generator
5
X , given by (3.8)

A
t
S
S X
5
c
c
+
c
c
=
In order to find the invariant corresponding to this generator, we have to solve the
equation

t
dA
S
dS
=
The general solution of the above equation is given by

1
C A S ln t + =
Therefore the invariant associated to the generator
5
X , is
S ln t A y = (B.1)
Considering the substitution
) t , y ( u ) t , A , S ( V = (B.2)
we can transform the partial derivatives:

y t t
u ) S (ln u V =
t V S
S
=

y yy
2
SS
2
u t u t V S + =
Using the previous substitutions, equation (3.1) is transformed to
0 u r u t
2
1
u t r
2
1
u
yy
2 2
y
2
t
= +
|
.
|

\
|
+ (B.3)
Under the substitution
z ln y = (B.4)
32
we find for the partial derivatives

z y
u z u = and
z zz
2
yy
u z u z u + =
Therefore equation (B.3) takes the form
0 u r u z t
2
1
u z t
2
1
t r
2
1
u
zz
2 2 2
z
2 2 2
t
= +
)
`

+
|
.
|

\
|
+ (B.5)
which is a Black-Scholes equation (Black and Scholes [10], Wilmott [49]) with
time-dependent coefficients.
Appendix C.
The Lie Algebra of the infinitesimal transformations of the constant-coefficient
Black-Scholes equation
0 F r
S
F
S r
S
F
S
2
1
t
F
2
2
2 2
=
c
c
+
c
c
o +
c
c
(C.1)
contains the two generators

F
F
c
c
and
t c
c
(C.2)
of its underlying symmetries.
We consider the linear combination of the above generators ( is a constant to be
determined)

t F
F
c
c
+
c
c
(C.3)
and try to determine the corresponding invariant to the (C.3). Solving the equation
dt
F
dF
= (C.4)
we find as the general solution C t F ln + = , from which we determine one
invariant G:
) S , t ( G e ) S , t ( F
t
= (C.5)
We then substitute (C.5) into (C.1) and we obtain the equation
33
0 G ) r (
S
G
S r
S
G
S
2
1
t
G
2
2
2 2
= +
c
c
+
c
c
o +
c
c

The choice r = removes the last term of this equation, leading to
0
S
G
S r
S
G
S
2
1
t
G
2
2
2 2
=
c
c
+
c
c
o +
c
c
(C.6)
which is a simplified version of the original equation (C.1).
Therefore the transformation
) S , t ( G e ) S , t ( F
) t T ( r
= (C.7)
converts equation (C.1) into (C.7), where T is the strike time.
We can further transform equation (C.6) into the Heat Equation. The crucial point
is that equation (C.6) contains
S
S
c
c
as generator of its infinitesimal Lie
symmetries. Therefore we introduce the transformation

)
`

= t
+ =
) t ( b
) t ( a S ln
(C.8)
where ) t ( a and ) t ( b are functions to be determined next.
Under this transformation, since
) t ( a
G
) t ( b
G
t
G
'
c
c
+ '
t c
c
=
c
c

and

c
c
=
c
c G
S
G
S ,
c
c

c
c
=
c
c G G
S
G
S
2
2
2
2
2

equation (C.6) transforms into
0
G
r
G G
2
1
) t ( a
G
) t ( b
G
2
2
2
=
c
c
+
|
|
.
|

\
|
c
c

c
c
o +
|
|
.
|

\
|
'
c
c
+ '
t c
c

which is equivalent to
34
0
G
r
2
1
) t ( a
G
2
1
) t ( b
G
2
2
2
2
=
c
c
|
.
|

\
|
+ o ' +
c
c
o + '
t c
c
(C.9)
The choices

2
2
1
) t ( b o = ' and 0 r
2
1
) t ( a
2
= + o ' (C.10)
convert equation (C.9) into the heat equation

2
2
G G
c
c
=
t c
c
(C.11)
Therefore the required transformation, coming from (C.10), reads
) t T (
2
1
) t ( a
2
o = and ) t T (
2
1
r ) t ( b
2

|
.
|

\
|
o = (C.12)
where again T is the strike time.

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