Enhancing the Black-Scholes Model: A Multi-Factor Approach

Introduction Analytical Solution

The Black-Scholes model, since its inception in the
early 1970s [1], has been pivotal in financial mathemat-
ics, offering a fundamental framework for pricing op-
tions and understanding derivative markets. Despite its
widespread adoption and substantial impact on modern
finance, the model encounters challenges in accurately
solving its partial differential equation, particularly in
complex real-world financial scenarios. While analytical
solutions suffice for simplified cases, numerical methods
are essential for efficiently managing diverse market con-
ditions and derivative products.
Research on the Black-Scholes model and equation (BS-
equation and BS-model) is vibrant, with numerous schol-
ars making significant contributions.
Alonso and Haida [2] recently utilized AI algorithms to
reformulate the Black-Scholes equation, while in [3], au-
thors proposed a solution to a modified version of the
equation using a combination of finite difference and frac-
tional differential transformation methods. Additionally,
researchers worldwide are actively developing new formu-
lations and methods for solving the Black-Scholes equa-
tion. For instance, Sah et al. [4] in India recently intro-
duced a numerical method, and Dr. Alpesh Kumar et al.
[5] presented a meshless solution.
Now going back to BS equation let w(x, t) denotes the
option value relative to the stock price and w1 represents
its partial derivative with respect to x, w2 and w11 are
similarly defined. Assuming constant variance rate of re-
turn v 2 , the linear Black-Scholes equation[1] is:
1
w2 = rw − rxw1 − v 2 x2 w11 (1)
2
If t∗ is maturation date, and c be exercise price then we
know that
(
∗ x−c x≥c
w(x, t ) = (2)
0 x<c
In this model, the short-term interest rate (r) remains
constant, stock prices (x) follow a continuous-time ran-
dom walk, and European options are traded without
transaction costs. Borrowing is allowed at the short-term
interest rate, and short selling doesn’t incur penalties [1].
Merten further expanded this formulation and showed
(in [6]) it could be derived from weaker condi-
tions.Furthermore in [7] , Barles formulated a nonlinear
Black-Scholes equation with adjusted volatility based on
the price’s second derivative.
In [1], Black and Scholes solve the B-S equation which is
∗
w(x, t) = xN (d1 ) − ce(t−t ) N (dw )
ln x/c + (r + 12 v 2 )(t∗ − t)
d1 = √
v t∗ − t
ln x/c + (r − 21 v 2 )(t∗ − t)
d2 = √
v t∗ − t
where , In this expression, N (b) is the cumulative normal
density function.
Numerical Solution
1. Finite Difference method FDM applies finite
differential representation (Taylor series) within a
local domain to solve system equations of strong-
form for an approximate solution [8].In [9] solved
BS equation by finite difference method.
2. Meshfree method An MFree method is a method
used to establish system algebraic equations for the
whole problem domain without the use of a prede-
fined mesh for the domain discretization.[8]
Work of Dr Alpesh kumar in [5] is meshless solution
of BS -equation.
Objectives
1. Explore advanced numerical solutions for the
Black-Scholes equation.
2. Apply innovative methods to improve its solution.
3. Solve broader cases to enhance its applicability.
4. Investigate machine learning algorithms for analy-
sis.
5. Explore its applications in diverse mathematical ar-
eas.
Methodology
Theoretical Analysis: Review PDE theory and numer-
ical methods.
Algorithm Development: Design numerical algo-
rithms for PDEs.
Model Integration: Integrate numerical methods with
financial models.
Validation and Backtesting: Validate models with
market data.

1
References
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81(3):637–654, 1973.
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fractional differential transformations to solve modified black–scholes fractional equations. Mathematics, 12(7),
2024.
[4] Kishun Kumar Sah and S Gowrisankar. Efficient numerical scheme for generalized black–scholes equations on
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pages 141–183, 1973.

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