Lie symmetry analysis on pricing weather derivatives by partial differential equations
Recently, stochastic differential equations have been proposed to model some weather derivatives. In this paper, the authors shed light on the irregularity of the rainfall intensity and the duration of the dry spells represented by the mean reverting Ornstein-Uhlenbeck process \((X_t)_t\) satisfying the stochastic differential equation: \[ dX_t=[k (\theta(t)-X_t)+\theta'(t)]dt+\sigma_tdW_t,\tag{1} \] where \(k\) is the rate of the mean reversion, \(\sigma_t\) is the volatility of the rainfall, \((W_t)_t\) is a Brownian motion, \(\theta(.)\) is the long term mean of the process \(X_t\) given by: \[ \theta(t)= m+\alpha \sin\big( \frac{\pi(t-v)}{6}\big)\tag{2} \] with \(v\) being the shift of the \(X-\)axis, \(m\) being the mean of the sine curve and \(\alpha\) determining the oscillation. Using Feynman-Kac Theorem, the underlying value of the weather option \(V(x, y, t)\) should satisfy the following partial differential equation (3): \[ \frac{\partial V}{\partial t}= r V- f(x)\frac{\partial V}{\partial y}-[k (\theta(t)-x)+\theta'(t)-\lambda\sigma_t]\frac{\partial V}{\partial x}-\frac12 \sigma_t^2\frac{\partial^2 V}{\partial^2x}.\tag{3} \] The equation is associated with the terminal condition: \( V(x, y, T)= \mathrm{tick}\times (S-Y(T))^+ \), where \( f(x)\) is the pay off function, \(\lambda\) is the market price of the risk, \(y(.)\) is the European input value of the Rain Defice Day (RDD), \(S\) is the strike level and ``tick is used to convert into monetary terms. Although the application of the Lie group classification show that the Eq. (3) cannot be reduced to a heat equation for any values of the parameters, the authors find an only two symmetries subalgebra that is used to reduce Eq. (3) by an independent variable. They determine, through Yu, Li and Chen algorithm, the one-dimensional optimal system of the algebra. The optimal system allows to gather invariant solutions into equivalent classes. For the entire collection see [Zbl 1467.16001].
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