General properties of solutions to inhomogeneous Black-Scholes equations with discontinuous maturity payoffs (Q898553)

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General properties of solutions to inhomogeneous Black-Scholes equations with discontinuous maturity payoffs
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    General properties of solutions to inhomogeneous Black-Scholes equations with discontinuous maturity payoffs (English)
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    18 December 2015
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    A terminal value problem of an inhomogeneous Black-Scholes equation with the risk free short rate \(r(t)\), the dividend rate \(q(t)\) of the underlying asset, the volatility \(\sigma(t)\) of the underlying asset's price process, maturity payoff \(f(x)\), and inhomogeneous term \(g(x)\) is given by \[ \begin{aligned} &\frac{\partial V}{\partial t}+ \frac{\sigma^2(t)}{2} x^2 \frac{\partial^2 V}{\partial x^2} +(r(t)-q(t))x \frac{\partial V}{\partial x} -r(t)V+g(x)=0, \\ & 0\leq t<T,\,\, 0<x<\infty, \\ & V(x,T)=f(x).\end{aligned} \] The authors derive a representation of the solution to the considered terminal value problem and obtain the min-max estimates for the solution. Then it is studied the derivatives of the solution with respect to the stock price variable in the case with continuous terminal payoffs and inhomogeneous terms and the solution's monotonicity and convexity under the conditions of monotonicity and convexity of the functions \(f(x)\) and \(g(x)\). The derivatives with respect to the stock price variable in the case with discontinuous terminal payoffs or inhomogeneous terms, the gradient estimate, and the solutions' monotonicity are studied. An example of pricing of a defaultable coupon bond is presented.
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    inhomogeneous Black-Scholes equation
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    discontinuous maturity payoffs
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    representation of solution
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    min-max estimates
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    representation of the gradient of solution
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    gradient estimates
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    monotonicity
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    convexity
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    defaultable coupon bond
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