Black-scholes theory and diffusion processes on the cotangent bundle of the affine group

• Main Authors: Jayaraman, Amitesh S., Campolo, Domenico, Chirikjian, Gregory S.
• Other Authors: School of Mechanical and Aerospace Engineering
• Format: Article
• Language: English
• Published: 2021
• Subjects: Engineering::Mechanical engineering; Black-Scholes; Affine
• Online Access: https://hdl.handle.net/10356/146343
• Institution: Nanyang Technological University

The Black-Scholes partial differential equation (PDE) from mathematical finance has been analysed extensively and it is well known that the equation can be reduced to a heat equation on Euclidean space by a logarithmic transformation of variables. However, an alternative interpretation is proposed in this paper by reframing the PDE as evolving on a Lie group. This equation can be transformed into a diffusion process and solved using mean and covariance propagation techniques developed previously in the context of solving Fokker-Planck equations on Lie groups. An extension of the Black-Scholes theory with coupled asset dynamics produces a diffusion equation on the affine group, which is not a unimodular group. In this paper, we show that the cotangent bundle of a Lie group endowed with a semidirect product group operation, constructed in this paper for the case of groups with trivial centers, is always unimodular and considering PDEs as diffusion processes on the unimodular cotangent bundle group allows a direct application of previously developed mean and covariance propagation techniques, thereby offering an alternative means of solution of the PDEs. Ultimately these results, provided here in the context of PDEs in mathematical finance may be applied to PDEs arising in a variety of different fields and inform new methods of solution.