I know the derivation of the Black-Scholes differential equation and I understand (most of) the solution of the diffusion equation. What I am missing is the transformation from the Black-Scholes differential equation to the diffusion equation (with all the conditions) and back to the original problem.
All the transformations I have seen so far are not very clear or technically demanding (at least by my standards).
My question:
Could you provide me references for a very easily understood, step-by-step solution?
Answer
One starts with the Black-Scholes equation ∂C∂t+12σ2S2∂2C∂S2+rS∂C∂S−rC=0,(1)
Step 1. The equation can be rewritten in the equivalent form ∂C∂t+12σ2(S∂∂S)2C+(r−12σ2)S∂C∂S−rC=0.
Step 2. If we replace C(y,τ) in equation (3) with u=erτC, we will obtain that ∂u∂τ−12σ2∂2u∂y2−(r−12σ2)∂u∂y=0.
Step 3. Finally, the substitution x=y+(r−σ2/2)τ allows us to eliminate the first order term and to reduce the preceding equation to the form ∂u∂τ=12σ2∂2u∂x2
Now, if we evaluate the integral with our specific function u0 and return to the old variables (x,τ,u)→(S,t,C), we will arrive at the usual Black–Merton-Scholes formula for the value of a European call. The details of the calculation can be found e.g. in The Mathematics of Financial Derivatives by Wilmott, Howison, and Dewynne (see Section 5.4).
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