Adaptive stochastic weak approximation of degenerate parabolic equations of Kolmogorov type

Degenerate parabolic equations of Kolmogorov type occur in many areas of analysis and applied mathematics. In their simplest form these equations were introduced by Kolmogorov in 1934 to describe the probability density of the positions and velocities of particles but the equations are also used as prototypes for evolution equations arising in the kinetic theory of gases. More recently equations of Kolmogorov type have also turned out to be relevant in option pricing in the setting of certain models for stochastic volatility and in the pricing of Asian options. The purpose of this paper is to numerically solve the Cauchy problem, for a general class of second order degenerate parabolic di¤erential operators of Kolmogorov type with variable coe¢ cients, using a posteriori error estimates and an algorithm for adaptive weak approximation of stochastic di¤erential equations. Furthermore, we show how to apply these results in the context of mathematical …nance and option pricing. The approach outlined in this paper circumvents many of the problems confronted by any deterministic approach based on, for example, a …nite-di¤erence discretization of the partial di¤erential equation in itself. These problems are caused by the fact that the natural setting for degenerate parabolic di¤erential operators of Kolmogorov type is that of a Lie group much more involved than the standard Euclidean Lie group of translations, the latter being relevant in the case of uniformly elliptic parabolic operators. 2000 Mathematics Subject Classi…cation: 35K65, 60H07, 60H30, 65C05, 91B28.