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TheGhostInside

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Is this equation a stochastic differential equation, or a PDE?

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- Thread starter TheGhostInside
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In summary, the Black-Scholes equation used in finance to price options based on underlying assets is both a stochastic differential equation and a PDE. This is because it is equivalent to the Fokker-Planck equation, which is a PDE for the probability density of finding the system at a certain value at a given time. This can be extended to more variables as well.

- #1

TheGhostInside

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Is this equation a stochastic differential equation, or a PDE?

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- #2

Mute

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Basically, if you have a stochastic differential equation with brownian noise,

e.g.,

$$dX_t = a(X_t,t)dt + b(X_t,t)dB_t,$$

then one can show that this is equivalent to a PDE called the Fokker-Planck equation:

$$\frac{\partial f(x,t)}{\partial t} = -\frac{\partial}{\partial x}\left[a(x,t)f(x,t)\right] + \frac{1}{2}\frac{\partial^2}{\partial x^2}\left[ b(x,t)^2 f(x,t)\right],$$

where f(x,t) is the probability density of finding the system to have a value of x between x and x+dx at a time t.

This generalizes to more variables (see the Fokker-Planck wikipedia page for a brief intro and some further references).

The Black-Scholes equation is a mathematical model used to calculate the theoretical value of European-style options. It takes into account factors such as the current stock price, strike price, time to expiration, and volatility to determine the fair price of an option.

Yes, the Black-Scholes equation is a partial differential equation. It is derived from the principles of financial economics and uses the concept of continuous time and continuous trading to model the behavior of options over time.

The Black-Scholes equation was developed by economists Fischer Black, Myron Scholes, and Robert Merton in 1973. They were awarded the Nobel Prize in Economics in 1997 for their contributions to the field of financial economics.

The Black-Scholes equation revolutionized the field of financial economics by providing a mathematical framework for pricing options. It is widely used by traders, investors, and financial institutions to determine the fair value of options and make informed investment decisions.

While the Black-Scholes equation is a valuable tool for pricing options, it has some limitations. It assumes that market conditions remain constant over time, which may not always be the case. It also does not take into account factors such as dividends or transaction costs, which can affect the actual value of an option.

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