Partial Differential Equations

Sam Howison and Christoph Reisinger

October 14, 2010

Sam Howison and Christoph Reisinger Partial Differential Equations

Literature

◮ W. E. Williams, Partial Differential Equations. OUP, 1980.

◮ Lawrence C. Evans: Partial Differential Equations. AMS, 2004
◮ J. Ockendon, S. Howison, A. Lacey, A. Movchan: Applied
Partial Differential Equations. OUP, 2003.

Sam Howison and Christoph Reisinger Partial Differential Equations

Aims

◮ derive closed-form solutions for special PDEs

◮ discuss the types of PDEs and the role of individual terms
◮ discuss boundary conditions and their relevance for the
uniqueness of solutions
◮ discuss the qualitative behaviour of solutions: smoothness,
extrema,...

Sam Howison and Christoph Reisinger Partial Differential Equations

Part I

Solution techniques

Sam Howison and Christoph Reisinger Partial Differential Equations

Heat equation

We start with the heat equation

1
ut = uxx ,
2
on the infinite interval −∞ < x < ∞, and for t > 0.
Supplemented with the initial condition

u(x, 0) = u0 (x)

this becomes an initial value problem.

Sam Howison and Christoph Reisinger Partial Differential Equations

Separation of variables

If we look for separable solutions u(x, t) = X (x) · T (t), then

Ṫ (t) 1 X ′′ (x) 1
= =: κ.
T (t) 2 X (x) 2

Therefore
1
T (t) = T (0)e 2 κt
and the asymptotic behaviour indicates 0 > κ =: −ω 2 . Then

X (x) = a sin ωx + b cos ωx

= Ae−iωx + Beiωx .

Sam Howison and Christoph Reisinger Partial Differential Equations

Finite interval

On a finite interval, say [0, π], boundary conditions dictate ω = n

an integer, which gives
1 2 1 2
sin nxe− 2 n t , cos nxe− 2 n t .

Then try a Fourier series

∞
X 1 2
u(x, t) = an sin nxe− 2 n t

n=1

if u = 0 at x = 0, π.
This only works (for periodic initial values or) on a finite interval,
and is therefore of limited use for most applications in finance.

Sam Howison and Christoph Reisinger Partial Differential Equations

Fourier transform

On an infinite interval, we can write

Z ∞
1 2
u(x, t) = g (ω)e− 2 ω t e−iωx dω
−∞

and Z ∞
u(x, 0) = g (ω)e−iωx dω.
−∞
Thus define the Fourier transform
Z ∞
ˆ 1
f (ω) = √ f (z)eiωz dz
2π −∞
with inverse Z ∞
1
f (z) = √ fˆ(ω)e−iωz dω.
2π −∞

Sam Howison and Christoph Reisinger Partial Differential Equations

Transformation of derivatives
Differentiation is multiplication in Fourier space:

fˆ′ (ω) = −iω fˆ(ω)

Therefore, Fourier transform the heat equation with respect to x,

∂û c
∂u 1 ∂d
2u 1
= = 2
= − ω 2 û.
∂t ∂t 2 ∂x 2
As before, we get an ODE in t with solution
1 2
û(ω, t) = û(ω, 0)e− 2 ω t ,

and transform back to

Z ∞
1 −(s−x)2
u(x, t) = √ u(s, 0)e 2t ds.
2πt −∞

Sam Howison and Christoph Reisinger Partial Differential Equations

Transformation in time

If we transform in time as well,

   
∂u ∂ 2 u 1 2
F − 2 (iω1 , iω2 ) = ω1 + ω2 û(iω1 , iω2 ) = 0.
∂t ∂x 2

ω1 = − 12 ω22 describes a parabola.

∂2u ∂2u
+ =0
∂x12 ∂x22

is an elliptic equation,

∂2u ∂2u
− =0
∂x12 ∂x22

hyperbolic.

Sam Howison and Christoph Reisinger Partial Differential Equations

Example

Consider the initial value problem


∂u 1 ∂2u 0 x >0
= , u(x, 0) =
∂t 2 ∂x 2 1 x <0

Then, from the above

Z ∞ Z 0
1 −(x−y )2 /2t 1 2
u(x, t) = √ e u(y , 0) dy = √ e −(x−y ) /2t f (y )
2πt −∞ 2πt −∞
√
Then put s = (y − x)/ t to get
Z √  
−x/ t
1 −s 2 /2 x
u(x, t) = √ e ds = N − √ .
2π −∞ t

where N is the cumulative distribution function for the standard

normal distribution.
Sam Howison and Christoph Reisinger Partial Differential Equations
Error function

The N function is closely related to “error” functions.

√
Alternatively, we could have put s ′ = −(y − x)/ t to get
Z ∞  
1 −s ′ 2 ′ 1 x
u(x, t) = √ √ e ds = 2 erfc √ .
π x/ t t

This particular solution is important for understanding “Binary” or

“Digital” options which pay out a fixed amount if and only if the
asset price at time t = T is below (for a Digital Put, or above for
a Digital Call) a certain fixed price. In our example this is captured
by the step function initial condition.

Sam Howison and Christoph Reisinger Partial Differential Equations

Similarity solutions
The heat equation is invariant under the scaling

x = λX
t = λ2 T

This suggests that there should be solutions

√
u(x, t) = f (x/ t)

as √ √ √
x/ t = λX / λ2 T = X / T .
√
Indeed, for ξ = x/ t
f ′′ = −ξf ′ ,
with solution Z ξ
2 /2
f =A e−s ds + B.
−∞

Sam Howison and Christoph Reisinger Partial Differential Equations

Similarity solutions

Of course this is a special (1-D) solution and it is only useful if the

initial/boundary conditions are also invariant under the
transformation.
E.g. if 
∂u 1 ∂2u 1 x >0
= , u(x, 0) =
∂t 2 ∂x 2 0 x <0
√
try u(x, t) = f (x/ t) where f (−∞) = 0, f (∞) = 1.
Then from above
Z ξ
2
f =A e−s /2 ds + B
−∞
√
where A = 1/ 2π, B = 0 to satisfy boundary conditions.

Sam Howison and Christoph Reisinger Partial Differential Equations

More similarity solutions

The heat equation is also invariant under the rescaling u = λU.

Moreover, if u is a solution, then ∂u ∂u
∂t and ∂x etc are also solutions,
which gives rise to solutions of the form
√
u(x, t) = t α f (x/ t)

and now
1 1
αf − ξf ′ = f ′′ .
2 2

Sam Howison and Christoph Reisinger Partial Differential Equations

Conservation laws
Note that
Z Z ∞ Z ∞
d ∞
u(x, t) dx = ut (x, t) dx = uxx (x, t) dx = 0
dt −∞ −∞ −∞

provided ux → 0 at ±∞. To find a similarity solution whose

integral is constant try
√
u(x, t) = t α f (x/ t)
then
Z ∞ Z ∞ Z ∞
α
√
u(x, t) dx = t f (x/ t) dx = t α+1/2 f (s) ds
−∞ −∞ −∞

so if α = − 12 the integral is constant.

The solution is
1 −x 2 /2t
u(x, t) = √ e
2πt
if we choose the integral to be 1.
Sam Howison and Christoph Reisinger Partial Differential Equations
Distributions
This solution is the so-called source solution
1 2
uδ (x, t) = √ e −x /2t .
2πt
Now consider the integral
Z ∞
lim uδ (y , t)f (y ) dy .
t→0 ∞
√
Write s = y / 2t so that this integral becomes
Z ∞ √
1 2
lim √ e −s f ( 2t s) ds.
t→0 π −∞
Then in the limit t → 0 this becomes
Z ∞
1 2
f (0) √ e −s ds = f (0).
π −∞

Sam Howison and Christoph Reisinger Partial Differential Equations

Distributions

Thus Z ∞
lim uδ (y , t)f (y ) dy = f (0).
t→0 −∞

A simple reworking of this argument shows that

Z ∞
lim uδ (x − y , t)f (y ) dy = f (x).
t→0 −∞

Now consider the function

1 2
uδ (x − y , t) = √ e −(x−y ) /2t .
2πt
Since the heat equation is constant coefficient, if uδ (x, t) is a
solution, so too is uδ (x − y , t), for any y .

Sam Howison and Christoph Reisinger Partial Differential Equations

Distributions
Since the heat equation is linear, if uδ (x − y , t) is a solution, so is
f (y )uδ (x − y , t).
The heat equation is linear so we can also add solutions. Since
f (y )uδ (x − y , t) is a solution for any y , so too is the integral
Z ∞
uδ (x − y , t)f (y ) dy .
−∞

Thus the solution of the initial value problem

∂u 1 ∂2u
= , u(x, 0) = f (x)
∂t 2 ∂x 2
is Z ∞
1 2 /2t
u(x, t) = √ e −(x−y ) f (y ) dy .
2πt −∞
Note that this solution blows up if we put t < 0 into it.
Sam Howison and Christoph Reisinger Partial Differential Equations
Black-Scholes
Now consider the Black-Scholes equation

∂V 1 ∂2V ∂V
+ σ 2 S 2 2 + (r − D)S − rV = 0
∂t 2 ∂S ∂S
We could look for separable solutions of the form

V (S, t) = f (S)g (t)

so with ˙ = d/dt and ′ = d/dS,

∂V ∂V ∂2V
= f (S)ġ (t), = f ′ (S)g (t), = f ′′ (S)g (t)
∂t ∂S ∂S 2
which gives

f (S)ġ (t) + 12 σ 2 S 2 f ′′ (S)g (t) + (r − D)Sf ′ (S)g (t) − rf (S)g (t) = 0.

Sam Howison and Christoph Reisinger Partial Differential Equations

Separation of variables

Now divide through by f (S)g (t) to get

1 2 2 ′′
ġ (t) σ S f (S) + (r − D)Sf ′ (S)
− +r = 2 =λ
g (t) f (S)

for some constant λ. Then, rearranging

ġ (t) = (r − λ)g (t)

and
1 2 2 ′′
2 σ S f (S) + (r − D)Sf ′ (S) − λf (S) = 0.

Sam Howison and Christoph Reisinger Partial Differential Equations

Separation of variables

These are a first order linear and an Euler equation for g (t) and
f (S) respectively.
Having observed this, a slightly easier way to go about it is to try a
solution of the form
V (S, t) = e αt S β .
There is a very important simple case, where we consider

f (S) ∝ S

Insertion into the ODE for f , noting f ′′ = 0, constrains λ = r − D.

The g -ODE then becomes:

ġ (t) = Dg (t)

so that g (t) ∝ e {Dt} .

Sam Howison and Christoph Reisinger Partial Differential Equations

Example

If we impose the condition that V = S at say time t = T we arrive

at the solution
V = e {−D(T −t)} S
which is very important. Combining this with the S-independent
solution
e {−r (T −t)} K ,
we see that if V = S − K at time t = T , the solution at other
times is:
V = e {−D(T −t)} S − e {−r (T −t)} K .
This plays a role in put-call parity, which comes up later.

Sam Howison and Christoph Reisinger Partial Differential Equations

Transformation

We could also observe that a transformation of the form x = log S

will reduce that S part of the derivatives
2
1 2 2∂ V ∂V
2 σ S + (r − D)S − rV
∂S 2 ∂S
to the form
2
1 2∂ V ∂V
2 σ + (r − D − 12 σ 2 ) − rV
∂x 2 ∂x
to get the constant coefficient problem

∂V ∂2V ∂V
+ 21 σ 2 2 + (r − D − 21 σ 2 ) − rV = 0
∂t ∂x ∂x
We could now look for solutions V = V (t), V = V (x) and
V = F (x)g (t), but this would produce nothing new.
Sam Howison and Christoph Reisinger Partial Differential Equations
More similarity solutions

Because the equation is constant coefficient, we could try a

solution of the form V = f (x − ct), for constant c, since then

∂V
= −cf ′ (x − ct)
∂t
∂V ∂2V
= f ′ (x − ct), = f ′′ (x − ct)
∂x ∂x 2
where ′ denotes the derivative with respect to the argument of f .
Then we would obtain the second order ordinary differential
equation
1 2 ′′ 1 2 ′
2 σ f + (r − D − 2 σ − c)f − rf = 0

This would give us solutions of the form

V (S, t) = f (log(S) − ct).

Sam Howison and Christoph Reisinger Partial Differential Equations

More transformations
Another thing we could try is to simplify the constant coefficient
equation
∂V ∂V ∂V
+ 21 σ 2 + (r − D − 21 σ 2 ) − rV = 0.
∂t ∂x ∂x
By writing V (x, t) = e rt U(x, t), so
∂V ∂U ∂U
= re rt U + e rt = rV + e rt
∂t ∂t ∂t
we see that
∂V ∂U ∂V ∂U ∂2V 2
rt ∂ U
− rV = e rt = e rt , = e
∂t ∂t ∂x ∂x ∂x 2 ∂x 2
giving (since e rt 6= 0)
∂U ∂2U ∂U
+ 12 σ 2 2 + (r − D − 12 σ 2 ) = 0.
∂t ∂x ∂x
Sam Howison and Christoph Reisinger Partial Differential Equations
More transformations

Now write
x ′ = x − kt, t′ = t
so
∂ ∂t ′ ∂ ∂x ′ ∂ ∂ ∂
= ′
+ ′
= ′ − k ′,
∂t ∂t ∂t ∂t ∂x ∂t ∂x
∂ ′
∂t ∂ ′
∂x ∂
= ′
+
∂x ∂x ∂t ∂x ∂x ′
and
∂2 ∂2
= .
∂x 2 ∂x ′ 2
Then we find that
∂U 2
1 2∂ U ∂U
′
+ 2 σ 2
+ (r − D − 12 σ 2 − k) ′ = 0.
∂t ∂x ′ ∂x

Sam Howison and Christoph Reisinger Partial Differential Equations

More transformations
Choosing k = (r − D − 12 σ 2 ) gives

∂U 2
1 2∂ U
+ 2 σ = 0.
∂t ′ ∂x ′ 2
Finally, note that an option usually has an expiry date T
associated with it. If we write

τ = σ 2 (T − t ′ )

so
∂ ∂τ ∂τ ∂
= ′ ′ = −σ 2
∂t ′ ∂t ∂t ∂τ
we arrive at the heat equation or diffusion equation

∂U ∂2U
= 21 ′ 2 .
∂τ ∂x

Sam Howison and Christoph Reisinger Partial Differential Equations

ODEs
If we have a solution of this PDE, say Û(x ′ , τ ), then the
corresponding solution of the Black–Scholes equation is

V (S, t) =


e rt Û log(S) − (r − D − 21 σ 2 )t, σ 2 (T − t) .
Note that there are other ways of reducing the Black–Scholes
equation to the heat equation; this is just a relatively simple
method to show that it is possible. One solution can be written
down directly — if Û(x ′ , τ ) ∝ x we get the so-called
“log-contract”. If V = Z log(S/K ) at time t = T the solution to
the BS eqn with this terminal value is:

V (S, t) =


Ze −r (T −t) log(S) + (r − D − 12 σ 2 )(T − t) .

Sam Howison and Christoph Reisinger Partial Differential Equations

Part II

Properties of solutions

Sam Howison and Christoph Reisinger Partial Differential Equations

Smoothness

The solution to the initial value problem

1
ut =
uxx −∞<x <∞
2
u(x, 0) = u0 (x)

is analytic in x for each t > 0.

This can be seen by differentiating the solution
Z ∞
1 2
u(x, t) = √ u0 (s)e−(x−s) /2t ds
2πt −∞
with respect to x under the integral.

Sam Howison and Christoph Reisinger Partial Differential Equations

Speed of propagation

The fundamental solution

1 −x 2 /2t
√ e
2πt
illustrates that information propagates with infinite speed (you feel
the effect of the initial δ-distribution at x = 0 immediately at all
x 6= 0) but decays very rapidly.
This is in contrast e.g. to the advection equation

ut + aux = 0,

which is a hyperbolic equation.

Sam Howison and Christoph Reisinger Partial Differential Equations

Maximum principle

A powerful tool are so-called maximum principles of the following

form:
Let u be a solution of the above equation and

DT := (0, L) × (0, T ),

BT := [0, L] × {0} ∪ {0} × [0, T ] ∪ {L} × [0, T ],

then
max u = max u,
BT ∪DT BT

i.e. any maximum is attained at the boundary (weak maximum

principle).
In contrast, strong maximum principles establish that maxima of
non-constant solutions are only attained at the boundary.

Sam Howison and Christoph Reisinger Partial Differential Equations

Derivation

(Weak) maximum principles can be seen directly by observing that

for any interior maximum (x∗ , t∗ )

∂u ∂u ∂2u
(x∗ , t∗ ) = 0 (x∗ , t∗ ) = 0 and (x∗ , t∗ ) ≤ 0.
∂t ∂x ∂x 2
First consider
1
ut − uxx = F
2
with F (x, t) < 0.
Then it follows

uxx (x∗ , t∗ ) = −2F (x∗ , t∗ ) > 0,

which is a contradiction.

Sam Howison and Christoph Reisinger Partial Differential Equations

Derivation cont’d

Now consider
1
ut − uxx = 0
2
and put v = u + ǫx 2 so
1
vt − vxx = −ǫ < 0
2
and v cannot have an interior maximum. Letting ǫ → 0 we see

u ≤ max u.
BT

Sam Howison and Christoph Reisinger Partial Differential Equations

Extensions

For an equation of the type of the Black-Scholes equation

∂V 1 ∂2V ∂V
+ σ 2 S 2 2 + (r − D)S − rV = 0
∂t 2 ∂S ∂S
the relevant part of the boundary is

BT := [0, L] × {T } ∪ {0} × [0, T ] ∪ {L} × [0, T ],

(final value problem!), and for r > 0 the result holds in the weaker
form
max u + = max u + ,
BT ∪DT BT

with u + = max(u, 0) i.e. any non-negative maximum is attained at

the boundary. [For Black-Scholes indeed the stronger result holds
by transformation.]

Sam Howison and Christoph Reisinger Partial Differential Equations

Consequences

Likewise, it can be shown that any (non-positive) minimum is

attained at the boundary (weak minimum principle).
By taking the difference between two solutions with the same
initial and boundary conditions it follows that
◮ solutions are unique.
By taking the difference between two solutions with different initial
and boundary conditions it follows that
◮ solutions depend continuously on the data.

Sam Howison and Christoph Reisinger Partial Differential Equations

Well-posedness

A problem is well-posed, if
◮ the solution exists,
◮ it is unique, and
◮ it depends continuously on the data.
We have seen that the heat equation is well-posed.
[We have cast aside a discussion of what class of solutions we
consider, or how we measure continuity.]

Sam Howison and Christoph Reisinger Partial Differential Equations

Backward equation

The backward heat equation

1
ut + uxx = 0
2
is the time reversal of ut − 12 uxx = 0.
The initial value problem for it is ill-posed.
In general, solutions cease to exist in finite time, e.g.
1 2
u=p e−x /2(T −t) .
2π(T − t)

Sam Howison and Christoph Reisinger Partial Differential Equations

Relation to Black-Scholes

However, the final value problem

1
ut + uxx = 0 t<T
2
u(x, T ) = uT (x)

is well-posed by time-reversal.
This is of fundamental importance in finance as many problems
have this structure of final value problems of a backward equation.

Sam Howison and Christoph Reisinger Partial Differential Equations