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Degenerate elliptic operators in mathematical finance and Holder continuity for solutions to variational equations and inequalities

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  • Paul M. N. Feehan
  • Camelia Pop
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    Abstract

    The Heston stochastic volatility process, which is widely used as an asset price model in mathematical finance, is a paradigm for a degenerate diffusion process where the degeneracy in the diffusion coefficient is proportional to the square root of the distance to the boundary of the half-plane. The generator of this process with killing, called the elliptic Heston operator, is a second-order, degenerate-elliptic partial differential operator whose coefficients have linear growth in the spatial variables and where the degeneracy in the operator symbol is proportional to the distance to the boundary of the half-plane. With the aid of weighted Sobolev spaces, we prove supremum bounds, a Harnack inequality, and H\"older continuity near the boundary for solutions to variational equations defined by the elliptic Heston operator, as well as H\"older continuity up to the boundary for solutions to variational inequalities defined by the elliptic Heston operator. In mathematical finance, solutions to obstacle problems for the elliptic Heston operator correspond to value functions for perpetual American-style options on the underlying asset.

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    File URL: http://arxiv.org/pdf/1110.5594
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    Bibliographic Info

    Paper provided by arXiv.org in its series Papers with number 1110.5594.

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    Date of creation: Oct 2011
    Date of revision: Feb 2013
    Handle: RePEc:arx:papers:1110.5594

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    1. Bates, David S, 1996. "Jumps and Stochastic Volatility: Exchange Rate Processes Implicit in Deutsche Mark Options," Review of Financial Studies, Society for Financial Studies, vol. 9(1), pages 69-107.
    2. JosE Da Fonseca & Martino Grasselli & Claudio Tebaldi, 2008. "A multifactor volatility Heston model," Quantitative Finance, Taylor & Francis Journals, vol. 8(6), pages 591-604.
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