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

Anant Srivastava
CRET Roll Number : 1934400114

Introduction Analytical Solution

In [1], Black and Scholes solve the B-S equation which is
The Black-Scholes model, since its inception in the ∗
w(x, t) = xN (d1 ) − ce(t−t ) N (dw )
early 1970s [1], has been pivotal in financial mathemat-
ics, offering a fundamental framework for pricing op- ln x/c + (r + 12 v 2 )(t∗ − t)
d1 = √
tions and understanding derivative markets. Despite its v t∗ − t
widespread adoption and substantial impact on modern ln x/c + (r − 21 v 2 )(t∗ − t)
finance, the model encounters challenges in accurately d2 = √
v t∗ − t
solving its partial differential equation, particularly in
complex real-world financial scenarios. While analytical where , In this expression, N (b) is the cumulative normal
solutions suffice for simplified cases, numerical methods density function.
are essential for efficiently managing diverse market con-
ditions and derivative products.
Research on the Black-Scholes model and equation (BS- Numerical Solution
equation and BS-model) is vibrant, with numerous schol-
ars making significant contributions. Alonso and Haida 1. Finite Difference method FDM applies finite
[2] recently utilized AI algorithms to reformulate the differential representation (Taylor series) within a
Black-Scholes equation, while in [3], authors proposed local domain to solve system equations of strong-
a solution to a modified version of the equation using a form for an approximate solution [8].In [9] solved
combination of finite difference and fractional differen- BS equation by finite difference method.
tial transformation methods. Additionally, researchers
2. Meshfree method An MFree method is a method
worldwide are actively developing new formulations and
used to establish system algebraic equations for the
methods for solving the Black-Scholes equation. For in-
whole problem domain without the use of a prede-
stance, Sah et al. [4] in India recently introduced a nu-
fined mesh for the domain discretization.[8]
merical method, and Dr. Alpesh Kumar et al. [5] pre-
Work of Dr Alpesh kumar in [5] is meshless solution
sented a meshless solution.
of BS -equation.
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 Objectives
similarly defined. Assuming constant variance rate of re-
turn v 2 , the linear Black-Scholes equation[1] is: 1. Explore advanced numerical solutions for the
Black-Scholes equation.

1 2. Apply innovative methods to improve its solution.

w2 = rw − rxw1 − v 2 x2 w11 (1)
2
3. Solve broader cases to enhance its applicability.
4. Investigate machine learning algorithms for analy-
If t∗ is maturation date, and c be exercise price then we
sis.
know that
5. Explore its applications in diverse mathematical ar-
( eas.
∗ x−c x≥c
w(x, t ) = (2)
0 x<c
Methodology
Theoretical Analysis: Review PDE theory and numer-
In this model, the short-term interest rate (r) remains ical methods.
constant, stock prices (x) follow a continuous-time ran- Algorithm Development: Design numerical algo-
dom walk, and European options are traded without rithms for PDEs.
transaction costs. Borrowing is allowed at the short-term Model Integration: Integrate numerical methods with
interest rate, and short selling doesn’t incur penalties [1]. financial models.
Merten further expanded this formulation and showed Validation and Backtesting: Validate models with
(in [6]) it could be derived from weaker condi- market data.
tions.Furthermore in [7] , Barles formulated a nonlinear
Black-Scholes equation with adjusted volatility based on
the price’s second derivative.

1
References
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pages 141–183, 1973.

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