Applications of symmetry analysis of partial differential and stochastic differential equations arising from mathematics of finance.

Abstract

In the standard modeling of the pricing of options and derivatives as generally understood these days the underlying process is taken to be a Wiener Process or a Levy Process. The stochastic process is modeled as a stochastic differential equation. From this equation a partial differential equation is obtained by application of the Feynman-Kac Theorem. The resulting partial differential equation is of Hamilton-Jacobi-Bellman type. Analysis of the partial differential equations arising from Mathematics of Finance using the methods of the Lie Theory of Continuous Groups has been performed over the last twenty years, but it is only in recent years that there has been a concerted effort to make full use of the Lie theory. We propose an extension of Mahomed and Leach's (1990) formula for the nth-prolongation of an nth-order ordinary differential equation to the nth-prolongation of the generator of an hyperbolic partial differential equation with p dependent and k independent variables. The symmetry analysis of this partial differential equation shows that the associated Lie algebra is {sl(2,R)⊕W₃}⊕s ∞A₁ with 12 optimal systems. A modeling approach based upon stochastic volatility for modeling prices in the deregulated Pennsylvania State Electricity market is adopted for application. We propose a dynamic linear model (DLM) in which switching structure for the measurement matrix is incorporated into a two-state Gaussian mixture/first-order autoregressive (AR (1)) configuration in a nonstationary independent process defined by time-varying probabilities. The estimates of maximum likelihood of the parameters from the "modified" Kalman filter showed a significant mean-reversion rate of 0.9363 which translates to a half-life price of electricity of nine months. Associated with this mean-reversion is the high measure of price volatility at 35%. Within the last decade there has been some work done upon the symmetries of stochastic differential equations. Here empirical results contradict earliest normality hypotheses on log-return series in favour of asymmetry of the probability distribution describing the process. Using the Akaike Information Criterion (AIC) and the Log-likelihood estimation (LLH) methods as selection criteria, the normal inverse Gaussian (NIG) outperformed four other candidate probability distributions among the class of Generalized Hyperbolic (GH) distributions in describing the heavy tails present in the process. Similarly, the Skewed Student's t (SSt) is the best fit for Bonny Crude Oil and Natural Gas log-returns. The observed volatility measures of these three commodity prices were examined. The Weibull distribution gives the best fit both electricity and crude oil data while the Gamma distribution is selected for natural gas data in the volatility profiles among the five candidate probability density functions (Normal, Lognormal, Gamma, Inverse Gamma and the Inverse Gaussian) considered.