A Remark on Approximation of the Solutions to Partial Differential Equations in Finance

Abstract

This paper proposes a general approximation method for the solution to a second-order parabolic partial differential equation (PDE) widely used in finance through an extension of Leandre's approach (Leandre, 2006, 2008) and the Bismut identiy (e.g. chapter IX-7 of Malliavin, 1997) in Malliavin calculus. We present two types of its applications, approximations of derivatives prices and short-time asymptotic expansions of the heat kernel.In particular, we provide approximate formulas for option prices under local and stochastic volatility models. We also derive short-time asymptotic expansions of the heat kernel under general time-homogenous local volatility and local-stochastic volatility models in finance, which include Heston (Heston, 1993) and (lambda-) SABR models (Hagan et.al., 2002, Labordere, 2008) as special cases. Some numerical examples are shown.