SEMINAR-1

BLACK-SCHOLES EQUATION WITH

FUZZY RATE OF INTEREST

NAME - SASWOTIKA RATH

REGD. NO. - 2161057013
SUPERVISOR : DR. MITALI MADHUSMITA NAYAK
 OUTLINES
• INTRODUCTION

• THE BLACK-SCHOLES(BS) EQUATION AND ITS SOLUTION

• FUZZY BLACK-SCHOLES EQUATION

 INTRODUCTION

The Black-Scholes Equation Is a Partial Differential Equation that describes the behavior of options,
which are financial instruments that give the holder the right to buy or sell an underlying asset at a
specified price and time. the equation is named after its creators, Fischer Black and Myron Scholes, who
developed it in the early 1970.

The Black-Scholes equation is a Parabolic Partial Differential equation in the form of:
2
V 1 2 2  V V
  S 2
 rS  rV  0 (1)
t 2 S S

where V is the price of the option as a function of the underlying asset S and time t, σ is the volatility of
 2V / S 2
the underlying asset, r is the risk-free interest rate, and ∂V/∂t, and ∂V/∂S are the first, second
and first partial derivative of V with respect to time, asset price respectively.
 Equation (1) with suitable final and boundary conditions i.e.,
V (0, t )  0
V (S , t )  S
as
S  
V ( S , T )  max( S  K , 0)

where V is the value of an option, r is the risk-free interest rate,𝜎 is the volatility and S is the price of
underlying asset at time t. This work focuses on finding the solution of Black-Scholes equation for European
call option. A European call option is the right but not obligation to purchase an underlying asset at the
exercise price K at the expiration time T. In fact, Options are the tools against the uncertainty of the market.
When someone writes an option, they allow someone else to reduce their risk of losing money by paying a fee
called the option price.
The solution of the BS equation has been considered in this work by transforming the equation in form of
heat equation.
 SOLUTION

A closed form solution can be found by transforming the BS equation into a heat equation by applying
suitable substitutions.
r 1
Let S  Ke x , t  T  , and V ( x, )  V ( S , t )
2 /2 K
The transformed heat equation is of the form

,   x  , 0  T   T
2 2
u  u
 2
T  x 2 (2)
1 1
( k 1) x ( k 1) x
with initial conditionu ( x, 0)  e 2 e 2

The closed form solution of the equation (2) for the European call option is given by
 r (T  t )
u ( S , t )  S (d 1)  K  e  (d 2 )
2

1
d y
Where  (d ) 
2
e

2 dyis the cumulative distribution function for the standard normal distribution and
log( S / K )  (r   )(T  t )
2

log( S / K )  ( r  
2

)(T  t )
2
d1  (T  t ) d 2
 2
 (T  t )
 FUZZY BLACK SCHOLES EQUATION

Since the market is uncertain, we consider fuzzy numbers to study the behavior of the risk-
free rate of interest, which affects the BS equation mostly.

BS equation with fuzzy rate of interest is in the form of :

2
V 1  V V
t 2 
2 2
 S S  
rS
2
S
 0
 rV

where we consider the triangular fuzzy number to describe the rate of interest.
The fuzzy risk-free interest rate, r(t), is modeled using fuzzy numbers, which
allows for a range of possible interest rates based on the degree of uncertainty or
fuzziness in the input data. This approach can provide more accurate estimates of
option prices in situations where interest rates are uncertain or may change over it.

The fuzzy Black-Scholes equation with a fuzzy risk-free interest rate can be
solved by analytically as well as numerically.
FUZZY SET:
A fuzzy number is a special case of a fuzzy set. different definitions and properties of fuzzy numbers
are encountered in the literature. but it actually represents the notation of a set of real numbers
‘closer to a’ where ‘a’ is the number being fuzzified. a fuzzy number is a fuzzy set which is both
convex and normal.

TRIANGULAR FUZZY
If r is a triangular fuzzy number then, it is represented by the triplet r   r1 , r2 , r3 
Where r  r   r2  r r3  r   3
1 1
The fuzzy number ris said to be triangular fuzzy number if it is fully determined by
 r1 , r2 , r3of crisp number such that  r1  rwhose
2  r3  membership function, representing

triangle, can be denoted by

  x  r1
r  r r1  x  r2
 2 1

r x
 r  x    3 r2  x  r3
 r3  r2
0 otherwise



Singed distance method for defuzzification

Let r be a fuzzy set defined on R, then the singed distance of ris defined as
1
1
d  r, 0     rL ( )  rR ( )  d
20
r  r1 ( )  r2 ( )   [r1  (r2  r1 ) , r3  (r3  r2 ) ],   [0,1] 
Where is an cut of a fuzzy set
r
,
FUTURE WORK:
The fuzzy Black-Scholes equation with a fuzzy risk-free interest rate can be
solved numerically by finite difference method.
REFERENCE
1. A course on ordinary and partial differential equation by J.Sinha Roy and S.Paadhy

2.Doghonay Arjmand. Highly accurate difference schemes for the numerical solution of

Third-order ordinary and partial differential equations. Skolan för datavetenskap och

Kommunikation, kungliga tekniska högskolan, 2010.

2. Finite difference methods for differential equations Randall J. Leveque DRAFT VERSION
for use in the course amath 585{586 university of washington version of september, 2005

3.Cen Z. And le A., "A robust and accurate finite difference method for a generalized black-

Scholes equation," elsevier, 2011.

THANK YOU