On Approximation of the Solutions to Partial Differential Equations in Finance (Revised in March 2012)

Abstract

This paper proposes a general approximation method for the solutions to second-order parabolic partial differential equations (PDEs) widely used in finance through an extension of L'eandre’s approach (L'eandre (2006,2008)) and the Bismut identiy (e.g. chapter IX-7 of Malliavin (1997)) in Malliavin calculus. We show two types of its applications, new approximations of derivatives prices and short-time asymptotic expansions of the heat kernel. In particular, we provide new approximation formulas for plain-vanilla and barrier option prices under stochastic volatility models. We also derive short-time asymptotic expansions of the heat kernel under general time-homogenous local volatility and local-stochastic volatility models in finance which include Heston (Heston (1993)) and (λ-)SABR models (Hagan et.al. (2002), Labordere (2008)) as special cases. Some numerical examples are shown.