1

A Brief Introduction to Differential Equations

Ordinary Differential Equations

A differential equation is linear if the unknown function, f(x), and all its derivatives are first
order in the equation. For example

( ) ( ) ( ) ( ) ( ) ( ) 0 P x f x Q x f x R x f x '' ' + + = (1)

is a linear while

2
( ) ( ) ( ) ( ) ( )[ ( )] 0
( ) ( ) ( ) ( ) ( ) 0
P x f x Q x f x R x f x
P x f x Q x f x f x
'' ' + + =
'' ' + =
(2)

are not. This is true regardless of the function forms of P, Q, and R. All three of these equations
are second order differential equations because the second derivative is the highest to appear. They
are also homogeneous equations because there is no term that does not depend on the unknown
function or its derivatives.

( ) ( ) ( ) ( ) ( ) ( ) ( ) P x f x Q x f x R x f x S x '' ' + + = (3)

is an example of an inhomogeneous equation. The S(x) term which does not depend on the
unknown function f(x) or its derivatives is what makes it inhomogeneous.
Linear differential equations, particularly of the first and second order, occur often in
problems of economics. Nonlinear equations can also be found. This note serves to introduce you
to some methods of solving them.


First Order Linear Differential Equations

A generic first order homogeneous differential equation is

( ) ( ) ( ) ( ) 0 P x f x Q x f x ' + = (4)

By treating the derivative as a fraction and formally manipulating it, we can re-write (4) as


( )
( )
df Q x
dx
f P x
= (5)
Integrating once gives


( ) ( ) ( )
n ( ) ( ) exp exp
( ) ( ) ( )
df Q x Q x Q x
f x c dx f x c dx C dx
f P x P x P x
( (
= + = = =
( (

} } } }
(6)

The constant c is the constant of integration and must be determined from other
information called a boundary condition (or often when x is time, an initial or terminal condition).
For example, consider the differential equation f' + (1 + 4x)f = 0 with f(0) = 1. Equation (6) gives
us f(x) = Cexp(x + 2x
2
) and we see that C must be 1 to satisfy the initial condition.
2

A generic first order inhomogeneous differential equation is

( ) ( ) ( ) ( ) ( ) P x f x Q x f x R x ' + = (7)

We solve linear inhomogeneous equations in two parts. First we solve the corresponding
homogeneous equation and next we add a particular solution to handle the inhomogeneous terms.
We can use this method on any linear equation because if f
h
and f
p

both satisfy a linear equation
then so does f
h
+ f
p
. The boundary condition is then applied to determine the constant. While the
homogeneous solution is unique up to the constant of integration, there are many particular
solutions.
Any particular solution suffices to solve the equation. Often a particular solution can be
determined by inspection. For example, consider the equation 1 . f f x ' + = + One particular
solution is clearly f(x) = x. When a particular solution cannot be determined by inspection, it can
be determined as follows. First find the homogeneous solution as in (6). Then guess a particular
solution of the form f
p
(x) = g(x)f
h
(x) and substitute this into (4)


| |
( )[ ( ) ( ) ( ) ( )] ( ) ( ) ( ) ( )
( ) ( ) ( ) ( ) ( ) ( ) ( ) ( ) ( )
h h h
h h h
P x f x g x f x g x Q x f x g x R x
g x P x f x Q x f x P x f x g x R s
' ' + + =
' ' + + =
(8)

The term in brackets is zero because f
h
(x) is a solution of the homogeneous equation. Now g can
be determined by integrating ( ) ( ) ( )
h
R x P x f x and from that f
p
can be determined


( )
( ) ( ) ( ) ( ) ( ) ( ) .
( ) ( )
p h h h
h
R
f x f x g x f x g x dx f x d
f P

' = = =

}
}
(9)

First Order Nonlinear Differential Equations

Nonlinear equations are much harder to solve. The generic nonlinear first order equation is
F(f', f, x) = 0. We will give solutions for a few special cases. Note the forms given below must
match exactly. Nonlinear differential equations cannot be solved in general by adding together
homogeneous and particular solutions.

Separable Equations: f' = g(f)h(x)

A separable first-order differential equation is one that can be written in the form f' is equal
to a product of functions of f and x.

( ) ( ( )) ( ) f x g f x h x ' = (10)

To solve a separable equation treat the derivative as a fraction and integrate

( ) ( ) ( ) ( ) .
( ) ( )
df df df
g f h x h x dx h x dx c
dx g f g f
= = = +
}
}
(11)

An example of a separable equation arising in economics is the model of cumulative
claims. The function f(t) is the cumulative claim as of time t. The model assumes that rate of
3
claims is proportional to both the number of remaining possible claims, ( ), f f t and (due to
publicity), the number of past claims, f(t). So the differential equation for f is

( ) ( )[ ( )] subject to (0) 1. f t kf t f f t f ' = = (12)

Using (11)

( )
1
n / ( ) 1
( )[ ( )]
df
kdt f f t kt C
f t f f t f
' = = +

(13)

Exponentiating gives / ( ) 1 .
f kt
f f t Ce

= Solving for f(t)

1
( ) 1
f kt
f t f Ce

(
= +

(14)

Applying the boundary condition gives

| |
1
1 (0) 1 1 f f C C f

= = + = (15)
so

1
( ) 1 ( 1) .
f kt
f t f f e

(
= +

(16)

Bernoulli Equations: P(x)f' + Q(x)f +R(x)f
o
= 0

A Bernoulli equation has the form

( ) ( ) ( ) ( ) ( ) ( ) 0 P x f x Q x f x R x f x
o
' + + = (17)

for o 1 (for o = 1 the equation is linear). To solve this problem let f(x) = w
1/(1o)
(x). Then f'(x) =
(1 o)
1
w
1/(1o)1
(x)w'(x), and the equation becomes


1/(1 ) 1 1/(1 ) /(1 )
1
0 ( ) ( ) ( ) ( ) ( ) ( ) ( )
1
1
( ) ( ) ( ) ( ) ( ) .
1
P x w x w x Q x w x R x w x
P x w x Q x w x R x
o o o o
' = + +
o
' = + +
o
(18)

This is a linear inhomogeneous equation in w which can be solved in the usual way.
An example of a Bernoulli equation arising in finance is in the intertemporal portfolio
choice problem. The derived utility function for an infinitely-lived investor with power utility can
be shown to be A(t)W

/, and the equation defining A(t) is

/( 1)
0 ( ) ( 1)[ ( ) ( )] subject to ( ) 0 . A t aA t A t A T

' = + = (19)

This is a Bernoulli equation with o = /( 1), P = 1, Q = ( 1)a, and R = 1 . So letting A(t)
= v
1
(t), we get

| |
0 (1 ) ( ) ( ) 1 . v x av x ' = + (20)

4
This equation has a particular solution of 1/a and a homogeneous solution of e
at
. So v(t) = Ce
at
+
1/a, and after applying the boundary condition, A(t) = a
1
[1 e
at
]
1
.


Homogeneous Equations: f' = F(f/x)

To solve the homogeneous equation

( ) ( ( ) / ) f x F f x x ' = (21)

Make the change of variable u(x) = f(x)/x. Then f'(x) = u(x) + xu'(x) and the equation is

( ) ( ) ( ( )) ( ) ( ( )) ( ) xu x u x F u x xu x F u x u x ' ' + = = (22)

which is a separable equation.
An example of a homogeneous equation model in economics is a simple growth model.
Suppose output per unit time is given by a Cobb-Douglas model AK
o
L
1o
. With a constant savings
rate, s, capital then grows at the rate

1
.
dK
sAK L
dt
o o
= (23)

Suppose also that the population and therefore labor, grows at the rate g. Then L = L
0
e
gt
.
Expressing capital as a function of labor, K = f(L), we have


1
[ ( ) ]
dK df dL df df sA
gL sAK L f L L
dt dL dt dL dL g
o o o
= = = = (24)

Defining u(L) = f(L)/L, we then apply (22) giving

( ) ( ) ( ) ( ) ( )
sA
Lu L u L u L u L u L
g
o o
' = = o (25)
so

1
1 1
n ( )
n
1
du dL u
L C u CL
u u L
o
o o
o
o
' = = + o =
o o

(26)

Since u(L) = K/L, we have


( )
1 1 1 1 1 1
0 0
K C L K K L L
o o o o o o
= + o = o (27)

Riccati Equations: f' = P(x)f
2
+ Q(x)f + R(x)
1


To solve the Riccati equation


2
( ) ( ) ( ) ( ) ( ) ( ) f x P x f x Q x f x R x ' = + + (28)

1
The Riccati equation is just an inhomogeneous form of a Bernoulli equation, but recall that nonlinear differential
equations cannot be solved by adding together particular and homogeneous solutions.
5

Make the change of variable


( ) exp ( ) ( )
( ) exp ( ) ( ) ( ) ( ) ( ) ( ) ( )
u x P x f x dx
u x P x f x dx P x f x u x P x f x
(
=

(
' = =

}
}
(29)

Now differentiate a second time and substitute for f' from (28) and u' from (29)


2
( ) ( ) ( ) ( ) ( ) ( ) ( ) ( ) ( ) ( )
( ) ( )[ ( ) ( ) ( ) ( ) ( )] ( ) ( ) ( ) ( ) ( ) ( ) ( ) ( )
( ) ( )[ ( ) ( ) ( )] ( ) ( ) ( )
u x u x P x f x P x f x u x u x f x P x
u x P x P x f x Q x f x R x P x f x u x P x f x u x f x P x
u x P x Q x f x R x u x f x P x
'' ' ' ' =
' = + + +
' = +
(30)

Then for u(x)f(x) substitute u'(x)/P(x) from (29)

( ) ( ) ( ) ( ) ( ) ( ) ( ) ( ) ( ) . u x u x Q x u x P x R x u x P x P x '' ' ' ' = + (31)

This gives a second order linear differential equation


2
0 ( ) ( ) [ ( ) ( ) ( )] ( ) ( ) ( ) ( ) . P x u x P x Q x P x u x P x R x u x '' ' ' = + + (32)

Once (31) is solved the original function f can be determined from (29) as


( )
( ) .
( ) ( )
u x
f x
u x P x
'
= (33)

An example of a Riccati equation arising in finance is the solution of the Cox-Ingersoll-
Ross term structure model. There an equation of the form


2
( ) ( ) ( ) 1 subject to (0) 0 B t aB t bB t B ' = = (34)

must be solved. This is a Riccati equation with P(x) = a, R(x) = b and Q(x) = 1. The second
order linear differential equation corresponding to (32) is


2
0 ( ) ( ) ( ) ( ) . au x aQ x u x a bu x '' ' = + (35)

The solution to (35) can be verified to be


(1 ) / 2 (1 ) / 2
1 2
where 1 4 .
t t
C e C e ab
+
+ + (36)

So using (33)

(1 ) / 2 (1 ) / 2 1 1 1 1
1 2 1 2 2 2 2 2
(1 ) / 2 (1 ) / 2
1 1 1 2
( )
( )
( )
t t t
t t t
C e C e C C e u t
B t
au t aC e aC e aC aC e
+ + +
+
' + +
= = =
+ +
(37)

Finally since B(0) = 0, C
2
= (1 + )C
1
/(1 ) and
6


( )
( )
1
1
(1 ) 1
( )
2 1
t
t
e
B t
a e

+
=

(38)

Note that the single boundary condition has determined both arbitrary constants. This is
fortunate since the original first-order equation only allows one boundary condition. Of course, it
is not a coincidence. It will always be true. The general solution u to (35) will be a linear
combination of the two homogeneous solutions C
1
u
1
+ C
2
u
2
, but f as given in (33) will be


2
1
2
1
1 2
1 1 2 2
1 1 2 2 1 2
( ) ( )
( ) ( ) ( )
( )
( ) ( ) ( )[ ( ) ( )] ( )[ ( ) ( )]
C
C
C
C
u x u x
C u x C u x u x
f x
u x P x P x C u x C u x P x u x u x
' ' +
' ' ' +
= = =
+ +
(39)

which has only a single arbitrary constant, C
1
/C
2
.


Second Order Linear Differential Equations

A generic second order differential equation is

( ) ( ) ( ) ( ) ( ) ( ) ( ) . P x f x Q x f x R x f x S x '' ' + + = (40)

If S(x) = 0, the equation is homogeneous. Otherwise it is inhomogeneous. The solution to (40) is

( )
1 1 2 2
( ) ( ) ( )
p
f x C f x C f x f x = + + (41)

where f
1
and f
2
are solutions to the homogeneous equation, f
p
is a particular solution, and C
1
and C
2

are constants to be determined by two boundary conditions.
There is no way to write the formal solution for all second order equation equivalent to (6)
for first order equations. One general case that can be handled is when R(x) = 0. In this case, the
equation is a first order differential equation in g(x) = f'(x).
The two types of second order equations arising most commonly in finance will be
discussed here.

Linear Second Order Equations with Constant Coefficients

The second order homogeneous equation with constant coefficients is

( ) ( ) ( ) 0 . af x bf x cf x '' ' + + = (42)

Both homogeneous solutions to this equation are of the form e
ox
. This can be determined by
substituting that form into the equation giving


2
[ ] 0 .
x
e a b c
o
o + o + = (43)

7
The expression in brackets is known as the characteristic equation for (42). Setting this to zero and
solving for the two values of o gives the two homogeneous solutions. Using the quadratic formula
we have

2
4
2
b b ac
a

o = (44)

Usually in finance problems, c < 0 < a, so the square root term is a real number and o
+
> 0
> o

. Then the solution to (42) is

1 2
.
x x
C e C e
+
o o
+ (45)

If b
2
4ac < 0, then the same solution can be applied with complex exponents. However the
solution is generally easier to interpret as


| |
/ 2 1 2
1 2
( ) sin( ) cos( ) where (2 ) 4 .
bx a
f x e C x C x a ac b

= + (46)

If b
2
= 4ac then the two roots of the characteristic equation are equal and the two solutions given in
(45) or (46) are the same. In this case the two homogeneous solutions are


/ 2 2
1 2
( ) ( ) when 4 .
bx a
f x e C C x b ac

= + = (47)

Particular Solutions for Constant Coefficient Equations

A particular solution can often be found by inspection. If the inhomogeneous term has a
special form, like a polynomial or exponential, then the method of undetermined coefficients can
be used. For example, if the inhomogeneous term is S(x) = Ke
kx
, a particular solution has the form
Ie
kx
. Substituting this into the equation gives


2
2
[ ] .
x x
K
e a b c Ke
a b c
k k
I k + k + = I =
k + k +
(48)

is a particular solution, provided k is not equal to o

.
If e
kx
is a homogeneous solution to the equation, then this method will not produce a
particular solution because ak
2
+ bk + c = 0. In this case a particular solution is Ixe
kx
. Substi-
tuting this into the equation gives


2
2
(2 ) ( )
( ) (2 ) .
2
x x x x x x
x x
Ke a e xe b e xe c xe
K
xe a b c e a b
a b
k k k k k k
k k
= kI + k I + I + kI + I
= I k + k + + I k + I =
k +
(49)

If the inhomogeneous term is
0 1
( ) ,
n
n
S x x x = | +| + +| then a particular solution is a
polynomial of the same order,
0 1
( ) .
n
p n
f x x x = + + Substituting this into the differential
equation and collecting like terms give


2 1
2 3 1 2
0 1 0 1
[2 6 ( 1) ] [ 2 ]
[ ] .
n n
n n
n n
n n
a x n n x b x n x
c x x x x

+ + + + + + +
+ + + + = | +| + +|


(50)
8

Equating terms with the same power of x gives n + 1 simultaneous equations for the coefficients

1 1
1 2 3 1
0 2 2 0
2 6
2
n n
n n n
c
c nb
c b a
c b a

= |
+ = |
+ + = |
+ + = |
(51)

These equations can be solved sequentially to determine the coefficients
i
.
For a general function S(x) the Wronskian method can be used. Since this method can be
used for all second order equations, the method is shown in general.

Wronskian Method for Particular Solutions

First we rewrite the second order equation in reduced form with the coefficient of f set to 1


( ) ( ) ( ) ( ) ( ) ( )
where ( ) ( ) ( ) ( ) ( ) ( ) ( ) ( ) ( ) .
f x q x f x r x f x s x
q x Q s P x r x R x P x s x S x P x
'' ' + + =
=
(52)

Once the homogeneous solution,
1 1 2 2
( ) ( ), C f x C f x + has been found, a particular solution can be
determined as
1 2
( ) ( ) ( ) ( ) ( )
p
f x u x f x v x f x = + . The derivatives of the particular solution are


1 1 2 2 1 2 1 2
1 1 2 2
by setting 0
p
p
f u f uf v f vf uf vf u f v f x
f u f uf v f vf
' ' ' ' ' ' ' ' ' = + + + = + + =
'' ' ' '' ' ' '' = + + +
(53)

Substituting these into the equation (52) gives


| | | |
| | | |
1 1 2 1 1 2
1 1 1 2 2 2 1 2
( ) ( ) ( )
( ) ( ) ( ) ( ) ( )
u f uf v f vf q x uf vf r x uf vf s x
u f q x f r s f v f q x f r s f u f v f s x
' ' '' ' ' '' ' ' + + + + + + + =
'' ' '' ' ' ' ' ' + + + + + + + =
(54)

The terms in brackets are both zero because f
1
and f
2
are solutions to the homogeneous equation.
Therefore, the functions u and v must satisfy the condition specified in (53) as well as the remain-
der of (54). Thus


1
1 2 1 2 1 2
1 2 1 2 1 2
0 0 0
or
u f v f f f f f u u
u f v f s f f f f v s v s

' ' ' ' + = | | | | | | | | | | | |

= =
| | | | | |
' ' ' ' ' ' ' ' ' ' + =
\ . \ . \ . \ . \ . \ .
(55)
and

2 1
1 2 2 1 1 2 2 1
( ) ( ) ( ) ( )
( ) ( ) .
( ) ( ) ( ) ( ) ( ) ( ) ( ) ( )
f x s x f x s x
u x v x
f x f x f x f x f x f x f x f x

' ' = =
' ' ' '
(56)

The particular solution
1 2
( ) ( ) ( ) ( ) ( )
p
f x u x f x v x f x = + can now be determined by integrating the
two derivatives, u' and v', in (56).
9
The expression in the denominators in (56) or the determinant of the matrix in (55) is
known as the Wronskian of the equation. That is,

( )
1 2 1 2 2 1
, ( ) ( ) ( ) ( ) . f f f x f x f x f x ' ' W (57)

For the constant coefficient equation, (42) with solution as given in (45), the Wronskian is


( )
1 2 1 2 2 1
2
( ) /
, ( ) ( ) ( ) ( )
4
( ) .
x x x x bx a
f f f x f x f x f x
b ac
e e e e e e
a
+ + +
o o o o o +o
+ +
' '

= o o = o o =
W
(58)

Euler Equation

The second order Euler equation is


2
( ) ( ) ( ) 0 . ax f x bxf x cf x '' ' + + = (59)
This equation can be solved by converting it to an equation with constant coefficients, by defining
z = n x and g(z) = f(x). Then f' = g'cz/cx = g'/x and f = (g/x)cz/cx g'/x
2
= g/x
2
g'/x
2
and the
equation becomes


2 2
[ ( ) ( )] ( ) ( ) ( ) ( ) ( ) ( ) 0 . ax g x g x x bx g x x cg x ag x b a g x cg x '' ' ' '' ' + + = + + = (60)

Alternatively, it can be solved directly by guessing the solution has the form Ax

and substituting
into (59) to get a quadratic equation in just as for the equation with constant coefficients.
This equation is very common in finance. The Black-Scholes option pricing equation for
infinitely-lived derivative assets based on a share of stock and receiving payments c(S) is


2
2 2
2
1
0 ( ) ( ) .
2
f f
S r q S rf c S
S S
c c
= o + +
c c
(61)

The general solution to this equation is


2 2 2 2
1 1
2 2
1 2 2
( ) ( ) 2
( ) ( ) where
p
r q r q r
f S C S C S f S
+

o o + o
= + +
o
(62)

The Wronskian for this equation is

( )
2
2( ) /
1 2 1 2 2 1
, ( ) ( ) ( ) ( ) ( ) .
r q
f f f x f x f x f x S
o
+
' ' = W (63)


Higher Order Linear Differential Equations

Higher order differential equations seldom arise in economics, but if they do they can be
solved in some of the same manners.
10
The n
th
order differential equation with constant coefficients has n solutions of the form e
ox
.
Determining the n values of o requires solving an n
th
degree polynomial. Substitute e
ox
into the
differential equation


( ) ( 1)
1 1 0
( ) ( ) ( ) ( ) 0
n n
n n
a f x a f x a f x a f x

' + + + + = (64)

to get the polynomial

1
1 1 0
0 .
n n
n n
a a a a

o + o + + o + = (65)

If the n roots are distinct, then the homogeneous solutions have been found. If the i
th
root is
double, then two homogeneous solutions are (C
i
+ C
i+1
x)exp(o
i
x). If the i
th
root is repeated k times
then k homogeneous solutions are (C
i
+ C
i+1
x + + C
k
x
k
)exp(o
i
x).
Similarly, the n
th
order Euler equation


( ) 1 ( 1)
1 1 0
( ) ( ) ( ) ( ) 0
n n n n
n n
a x f x a x f x a xf x a f x

' + + + + = (66)

has a homogeneous solution of

1 2
1 2
.
n
n
C x C x C x

+ + + (67)

If any root, , is repeated, then the two solutions are
1
( n ) .
i
i i
C C x x

+
+

Reduction of Order

If one (or more) homogeneous solutions to a differential equation is known, the equations
order can be reduced by one (or more) just as a polynomial equations order can be reduced if one
or more roots are known. Suppose f
1
(x) is a known solution to the second order equation

0 ( ) ( ) ( ) ( ) ( ) ( ) . P x f x Q x f x R x f x '' ' = + + (68)

Then define f
2
(x) = v(x)f
1
(x). Substituting this into (68) and collecting terms gives

| | | | | |
| |
1 1 1 1 1 1
1 1 1 1 1
1 1 1
0 ( )[ ( ) ( ) 2 ( ) ( ) ( ) ( )] ( )[ ( ) ( ) ( ) ( )] ( ) ( ) ( )
( ) ( ) ( ) ( ) ( ) ( ) ( ) ( ) ( ) ( ) 2 ( ) ( ) ( ) ( ) ( )
( ) ( ) ( ) 2 ( ) ( ) ( )
P x v x f x v x f x v x f x Q x v x f x v x f x R x v x f x
v x P x f x Q x f x R x f x P x f x v x P x f x Q x f x v x
P x f x v x P x f x Q x f
'' ' ' '' ' ' = + + + + +
'' ' '' ' ' = + + + + +
'' ' = + + | | ( ) ( ) . x v x '
(69)

This is a first order equation in v'(x).
This same method works with n
th
order differential equations. It also works successively if
multiple solutions are known.


Partial Differential Equations

Partial differential equations are equations in two or more variables. The most common
types of partial differential equations in economics are the parabolic and elliptical.
The parabolic equation has the form

11

2
2
( , ) ( , ) ( , )
( , ) ( , ) ( , ) ( , ) ( , ) .
f x t f x t f x t
a x t b x t c x t f x t s x t
x x t
c c c
+ + + =
c c c
(70)

The Black-Scholes partial differential equation is parabolic. Generally t measures time in a
parabolic equation. If the time derivative term has a coefficient other than 1, it can be put in this
form by dividing through by the coefficient. If s(x, t) = 0, the equation is homogeneous. There
must be one boundary condition for each derivative. So equation (70) must have two x boundary
conditions and one t condition for example, f(x, 0) = w(x), f(x, t) = h(t), ( , ) f x t = H(t) The
boundaries need not be at fixed values of x or time. For example we could have instead f(x(t), t) =
h(t).
The elliptical equation has the form


2 2 2
1 2 1 2 1 2
1 1 2 12 1 2 2 1 2 2 2
1 1 2 1
1 2 1 2
1 1 2 2 1 2 1 2
1 2
( , ) ( , ) ( , )
( , ) ( , ) ( , )
( , ) ( , )
( , ) ( , ) ( , ) ( , ) ( , )
f x x f x x f x x
a x x a x x a x x
x x x x
f x x f x x
b x x b x x c x x f x t s x t
x x
c c c
+ +
c c c c
c c
+ + + =
c c
(71)

with
2
12 11 22
4 a a a < .
2
Usually neither x is time in an elliptical equation. If s(x, t) = 0, the equation is
homogeneous. And again, there must be one boundary condition for each derivative. So equation
(70) must have two boundary conditions for each x for example, f(x
1
, 0) = w
2
(x
1
), f(x
1
, ) = 0,
f(0, x
2
) = w
1
(x
2
), f(, x
2
) = 0.
Partial differential equations can be quite difficult to solve. We will only deal with a few
methods here.

Using Homogeneity Properties

One way to solve partial differential equations is to use a homogeneity property of the
solution to reduce the number of variables in a partial differential equation. If the number of
variables is reduced to one, then the equation is an ordinary differential equation.
If by inspection of the equation or from economic intuition of the problem, it can be deter-
mined that the solution f(x
1
, x
2
) is homogeneous of degree , the partial differential equation can be
reduced to an differential equation. The solution is homogeneous of degree if f(sx
1
, sx
2
) =
s

f(x
1
, x
2
). If the equation is homogeneous, then make the substitutions f(x
1
, x
2
) =
1
( ) x g z

with z
x
2
/x
1
will reduce the equation to an ordinary equation. To use this method, the boundary conditions
must also satisfy the homogeneity condition.
As an example of applying homogeneity to solving partial differential equations, consider
the problem of pricing a power option to exchange. The payoff on this option is Max(S

, 0) at
time T. The partial differential equation for this problem assuming both assets have lognormal
distributions is


2 2 2
2 2 2 2
2 2
1 1
0
2 2
S A S A
f f f f f f
S SA A rS rA rf
S S A A S A t
c c c c c c
= o +o o + o + + +
c c c c c c c
(72)


2
If
2
12 11 22
4 , a a a > , then the equation is hyperbolic. If
2
12 11 22
4 , a a a = then the equation is a more general form of the
parabolic type.
12
As a first step to verify that f(S, A, t) = A

g(z, t) with z = S/A, we must show that the payoff

and other boundary conditions are homogeneous of degree . The terminal condition is because
f(S, A, T) = Max(S

, 0) = A

Max[(S/A)

1, 0], so g(z, T) = Max(z

1,0). The other

boundary conditions are f(0, A, t) = f(S, , t) = 0, f(S, 0, t) = S, and f(S, A, t)/S 1 as S .
These will be satisfied if g(0, t) = 0 and g(, t) = 1.
Next substituting the partial derivatives of g in place of f


1 1 1
2 2 2
1 2
2 2
2 2 2
1 2
2 2 2
2
2
2
[ ]
( 1) ( 1)
( 1)
f g z g f g z g f g
A g A A g z A A A
A z A z S z S z t t
f g g z g g
A z A z
A S z z S z z
f g z g
A A
S z S z
f g
A g z
A z

c c c c c c c c c c
= + = = = =
c c c c c c c c c c
( ( c c c c c c
= =
( (
c c c c c c c

c c c c
= =
c c c c
c c (
=

c c

2
1
2
2
2 2
2
( 1)
( 1) 2( 1) .
g g z
A z
z z A
g g
A g z z
z z

( c c c
+
(
(
c c c

( c c
= +
(
c c

(73)

into (72) we have


2 2
2 2 2 1
2 2
2
2 2 1
2
2
2 2 2 2 2
1
2 2
1
0 ( 1)
2
1
( 1) 2( 1) [ ]
2
1
0 ( 2 ) (1 )( ) (1 )( )
2
S A S
A
S A S A A S A A
g g g
A S A SA z
z z z
g g g g g
g z z rSA r g z rg
z z z z t
g g g
z z r g
z z

| ( c c c
= o o o

(
c c c
\
| ( c c c c c
+ o + + +
|
(
c c c c c
.
c c c
= o o o + o + o o + o + o +
c c c
.
t
(74)

Since only z appears here, we have verified the solution is of the form hoped for. In fact, this
equation is just the single-asset Black-Scholes partial differential equation in disguise with a
variance of
2 2
2
S A S A
o o o + o , an interest rate of
2
1
2
(1 )( ),
A
r + o and an expected growth rate in
the stock price of
2
(1 )( ).
A S A
o o + o
Note that it is important to check on the homogeneity properties of the boundary conditions
as well as of the partial differential equation. As we can see in (74), the partial differential equation
itself is homogeneous of degree o for any value o. It is the boundary which specifies which
degree to use. For example, a contract on the same two assets with a payoff of Max(S A
2
, 0) does
not have a price that is homogeneous of any degree in S and A even though the equation is still
homogeneous.

Change of Variable

Partial differential equations sometimes can be simplified by changing one or more of the
variables. For example, the problem just mentioned, an option with a payoff of Max(S A
2
, 0), is
13
not homogeneous, but can be solved with a change of variable. Define B A
2
and f(S, A, t) = h(S,
B, t). Then

2 2
2 2
2 2 2
2
2 2 2
2 2
2 2 2 2 2 4
2 2
df h d f h f h
S S S S t t
f h B h f h h h B h h
A A A A
A B A B A A B B B A B B
f f h h
A A
A S S A S B B S
c c c c
= = =
c c c c c c
c c c c c c c c c c c c (
= = = = + = +
(
c c c c c c c c c c c c

c c c c c c ( (
= = =
( (
c c c c c c c c

(75)

Equation (72) becomes


( )
2 2 2
2 2 2 2 2 2 2
2 2
2 2 2
2 2 2 2 2
2 2
1 1
0 2 2 4 2
2 2
1 1
2 4 2
2 2
S A S A
S A S A A
h h h h h h h
S SA A A rS rA rh
S S B B B S B t
h h h h h h
S SB B rS r B rh
S S B B S B t
( c c c c c c c
= o + o o + o + + + +
(
c c c c c c c c

c c c c c c
= o + o o + o + + + o +
c c c c c c c
(76)

with boundary condition h(S, B, T) = Max(S B, 0). This equation and boundary condition are
homogeneous of degree one in S and B and can be solved as before.

Simplification of Form

When a partial differential equation is not homogeneous, some other change in form might
yield a similar simplification. Simplification is possible when it can be determined that the
solution has a special form like f(x, t) = F(u(x)v(t)) or F(u(x) + v(t)) where something about F() or
u() or v() is known. Then solving the equation reduces to solving a set of simultaneous equations
for u and v.
An example of the simplification technique comes up in the Cox-Ingersoll-Ross term
structure model. In that model the partial differential equation is


2
2
( , ) ( , ) ( , )
( ) 0 subject to ( , ) 1.
f x t f x t f x t
ax c bx f x T
x x t
c c c
+ = =
c c c
(77)

The solution has the form ( ) ( , ) exp ( ) ( ) f x t A t B t x = + . Substituting this into (77) gives


( )
2
2
exp ( ) ( ) ( ) ( ) ( ) ( ) ( ) 0
( ) ( ) ( ) 0 ( ) ( ) 0 .
A t xB t axB t c bx B t A t xB t
aB t bB t B t cB t A t
' ' ( + + =

' ' = =
(78)

These two ordinary differential equation must be solved subject to A(0) = B(0) = 0. The equation
in B is the Riccati equation discussed above.

Transform Solutions of Partial Differential Equations

14
If the coefficients do not depend on time, and the x boundary conditions are applied at
constant values of x; i.e., f(x, t) = h(t) and ( , ) f x t = H(t), then a Laplace transform can be used to
solve the equation. That is, we can solve equations of the form


2
2
( , ) ( , ) ( , )
( ) ( ) ( ) ( , ) ( )
subject to ( , 0) ( ), ( , ) ( ), ( , ) ( ) .
f x t f x t f x t
a x b x c x f x t s x
x x t
f x w x f x t h t f x t H t
c c c
+ + + =
c c c
= = =
(79)

The Laplace transform of a function f(x, t) is defined as


0
( ; ) [ ( , )] ( , ) .
t
g x f x t e f s t dt

o
o =
}
(80)

To solve a partial differential equation using a Lapalce transform, multiply equation (79) by e
ot

and integrate term-by-term, integrating the time derivative term by parts,


2
2
0 0 0
0 0
2
2
0 0
2
2
( , ) ( , )
( ) ( ) ( ) ( , )
( , )
( )
( ; ) ( ; ) ( )
( ) ( ) ( ) ( ; ) ( , ) ( ) ( , )
( ; )
( ) (
t t t
t t
t t
t
f x t f x t
a x e dt b x e dt c x e f x t dt
x x
f x t
e dt s x e dt
t
g x g x s x
a x b x c x g x a e f x t e f x t dt
x x
g x
a x b x
x

o o o

o o

o o
=
c c
+ +
c c
c
+ =
c
c o c o
+ + + o =
c c o
c o
+
c
}
} } }
} }
( ; ) ( )
) ( ) ( ; ) ( ) ( ; ) .
g x s x
c x g x a w x g x
x
c o
+ + o o =
c o
(81)

The result is an ordinary second order differential equation


2
2
( ; ) ( ; ) ( )
( ) ( ) [ ( ) ] ( ; ) ( )
g x g x s x
a x b x c x g x a w x
x x
c o c o
+ + + o = +
c c o
(82)

With boundary conditions


0 0
0 0
( ; ) ( , ) ( ) [ ( )]
( ; ) ( , ) ( ) [ ( )] .
t t
t t
g x e f x t dt e h t dt h t
g x e f x t dt e H t dt H t

o o

o o
o = =
o = =
} }
} }

(83)

Equation (82) is an ordinary differential equation in g. If it can be solved and the inverse transform
is known, then


1
1 1 2 2
( , ) [ ( ; ) ( ; ) ( ; )] .
p
f x t C g x C g x g x a

= o + o + (84)

The Black-Scholes partial differential equation can be solved with Laplace transforms. The
partial differential equation and boundary conditions for a European put are

15

2
2 2
2
1
0
2
subject to (0, ) ( , ) 0 ( , 0) Max( , 0)
r
F F F
S rS rF
S S
F Xe F F S X S
t
c c c
= o +
c c ct
t = t = =
(85)

We have expressed the puts value in terms of the time to maturity t T t, so we can evaluate at t
= 0, as in the general case. Note that this changes the sign of the time derivative term and
therefore last two terms on the left-hand side of (81) are now w(x) og(). The modified equation
is

2
2 2
2
1 ( ; ) ( ; )
0 ( ) ( ; ) max( , 0) .
2
g S g S
S rS r g S a X S
S S
c o c o
= o + + o +
c c
(86)

This is an inhomogeneous ordinary differential equation of the Euler type. The boundary
conditions are

0 0
0 0
(0; ) (0, )
( ; ) ( , ) 0 0 .
r
t
X
g e F d e Xe d
r
g e F t d e d

ot ot t

ot o
o = t t = t =
+ o
o = t = t =
} }
} }
(87)

Because of the term max(X S, 0) the equation needs to be solved in two parts which are
matched at the point S = X. Therefore,


2 2
1
1 1 1 2
2 2
1
2 2 2 2
1 2 1 2 1 2
( ) 0
( )
( ) 0 (0) ( ) ( ) ( ) ( )
S g rSg r g S X
S g rSg r g S X S X
X
g g g X g X g X g X
r
'' ' o + + o = >
'' ' o + + o = <
' ' = = = =
+ o
(88)

We must match the first derivatives at S = X as well as value so the second derivative will be
defined.

The homogeneous solutions for g
1
and g
2
have the same form


1/ 2
2 2 2 2
1 1
2 2
2
( ) ( ) 2 ( )
where
r r r
AS BS
+

( o o + o + o

+
o
(89)

Note that o > 0; therefore,
+
> 0 >

. This requires that A = 0 for the g

1
solution and B = 0 for the
g
2
solution as they would otherwise be unbounded. The equation for g
1
is homogeneous. The
particular solution for g
2
is linear, g
2
(S) = a + bS. In particular,


2 2
1
2
1
0 ( )( )
X
S rSb r a bS S X a b
r
o + + o + = = =
+o o
(90)

So the solutions are

1 2
( ) ( )
X S
g S BS g S AS
r
+

= = + +
+o o
(91)

16
The boundary condition at S = 0 is met; matching the two solutions and derivatives at S = X
requires

1 1
1
and
X X
AX BX AX BX
r
+ +

+
+ + = + =
+ o o o
(92)

These are two linear equations in A and B with solution


( 2 ) ( )
.
X X A r X r
B X
X X
+
+


+
| | + o o + o | | | |
=
| | |
o

\ . \ .
\ .
(93)

Once the coefficients are determined the inverse transform is taken to give the Black-Scholes
option pricing function.

Superposition of Solutions

Superposition can be used if a solution to the same partial differential equation with a
different time boundary condition is known. Superposition in this case is the mathematical
equivalent of the law of one price.
For example, suppose we want to price a power option a contract with a payoff of
(S X)

when S > X and 0 otherwise. All European derivative assets are solutions to the Black-
Scholes equation

2
2 2
2
1
0 .
2
f f f
S rS rf
S S t
c c c
= o + +
c c c
(94)

So we need the solution to this equation with the terminal condition given.
Using superposition, we will form a portfolio of other contracts (whose values we know)
that match this payoff. An obvious set to use is regular call options whose payoffs are Max(S X,
0). We need to find a portfolio holding n(K) options with strike price K such that the portfolios
payoff matches the power calls. Of course, we will never be able to match this payoff exactly with
a finite number of options, so we are looking for a portfolio holding n(K)dK options in the interval
from K to K + dK. Clearly we only need to use options with strike prices at or above K. We are
looking for n(K) such that

( ) ( ) Max( , 0) ( )( ) .
S
X X
S X n K S K dK n K S K dK S X

= = >
} }
(95)

The value of n(K) that works is n(K) = ( 1)(K X)
2
since (integrating by parts)


2 1 1
1
( 1) ( ) ( ) ( ) ( ) ( )
0 ( ) ( ) ( )
S S S
K X X X
S S
K X X
K X S K dK K X S K K X dK
K X dK K X S X

=

=
=
= + = =
} }
}
(96)

Therefore, value of the power option is equal to the current value of this portfolio


2
Power option ( 1) ( ) ( , ; )
X
K X S t K dK

=
}
(97)

17
where is the Black-Scholes call option function


( )
2
1
2
( )
n ( / ) ( )
( , ; ) ( ) ( ) where .
r T t
S K r T t
S t K S h Ke h h
T t
+
+ o
u u
o

(98)

The key to this method is finding n(K). To apply this method in general for a generic
payoff of H(S) we need to determine the solution n(K) to


0 0
( ) ( ) Max( , 0) ( )( ) .
S
H S n K S K dK n K S K dK

= =
} }
(99)

This is a Volterra integral equation of the first type. It can be solved by differentiating twice with
respect to S


0 0 0
0
( ) ( )( ) ( )( ) ( ) ( )
( )
( ) ( ) ( ) .
S S S
S
d
H S n K S K dK n S S S n K dK n K dK
dS
dH S d
H S n K dK n S
dS dS
' = = + =
'
'' = = =
} } }
}
(100)

So for a generic payoff H(S), the value of the contract is


0
PV[ ( )] ( ) ( , ; ; ) .
T
H S H K S t T K dK

'' =
}
(101)

When using superposition, one must be careful to check the solution. Note that in equation
(100), the boundary condition must satisfy H(0) = H'(0) = 0. These conditions are necessary
because when S = 0, the upper and lower limits for the integrals in (99) and in the first line of (100)
are the same so the integrals and therefore the left-hand sides of the equation must be zero. If these
conditions are not met, call options cannot be used this way in the superposition. For example, this
result is not correct for < 1 when H' (0) = .
This same method works when we know a class of solutions index by some parameter, and
we can form a combination of those solutions that match the desired boundary condition. The
method does not depend on the portfolio interpretation given here.