A bubble is characterized by the presence of an underlying asset whose discounted price process is a strict local martingale under the pricing measure. In such markets, many standard results from option pricing theory do not hold, and in this paper we address some of these issues. In particular, we derive existence and uniqueness results for the Black-Scholes equation, and we provide convexity theory for option pricing and derive related ordering results with respect to volatility. We show that American options are convexity preserving, whereas European options preserve concavity for general payoffs and convexity only for bounded contracts.

In the present paper we find necessary and sufficient conditions on the coefficients of a parabolic equation for convexity to be preserved. A parabolic equation is said to preserve convexity if given a convex initial condition, any solution of moderate growth remains a convex function of the spatial variables for each fixed time.

Abstract. There are many references showing that a classical solution to the Black-Scholes equation is a stochastic solution. However, it is the converse of this theorem which is most relevant in applications and the converse is also more mathematically interesting. In the present article we establish such a converse. We find a Feynman-Kac type theorem showing that the stochastic representation yields a classical solution to the corresponding Black-Scholes equation with appropriate boundary conditions under very general conditions on the coefficients. We also obtain additional regularity results in the one-dimensional case.

We study the Black-Scholes equation in stochastic volatility models. In particular, we show that the option price is the unique classical solution to a parabolic differential equation with a certain boundary behaviour for vanishing values of the volatility. If the boundary is attainable, then this boundary behaviour serves as a boundary condition and guarantees uniqueness in appropriate function spaces. On the other hand, if the boundary is nonattainable, then the boundary behaviour is not needed to guarantee uniqueness, but is nevertheless very useful for instance from a numerical perspective.

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