LOCAL EQUIVALENCE OF THE BLACK–SCHOLES AND MERTON–GARMAN EQUATIONS

Abstract

IT HAS BEEN PREVIOUSLY DEMONSTRATED THAT STOCHASTIC VOLATILITY EMERGES AS THE GAUGE FIELD NECESSARY TO RESTORE LOCAL SYMMETRY UNDER CHANGES IN STOCK PRICES IN THE BLACK–SCHOLES (BS) EQUATION. WHEN THIS OCCURS, A MERTON–GARMAN-LIKE EQUATION EMERGES. FROM THE PERSPECTIVE OF MANIFOLDS, THIS MEANS THAT THE BLACK–SCHOLES AND MERTON–GARMAN (MG) EQUATIONS CAN BE CONSIDERED LOCALLY EQUIVALENT. IN THIS SCENARIO, THE MG HAMILTONIAN IS A SPECIAL CASE OF A MORE GENERAL HAMILTONIAN, HERE REFERRED TO AS THE GAUGE HAMILTONIAN. WE THEN SHOW THAT THE GAUGE CHARACTER OF VOLATILITY IMPLIES A SPECIFIC FUNCTIONAL RELATIONSHIP BETWEEN STOCK PRICES AND VOLATILITY. THE CONNECTION BETWEEN STOCK PRICES AND VOLATILITY IS A POWERFUL TOOL FOR IMPROVING VOLATILITY ESTIMATIONS IN THE STOCK MARKET, WHICH IS A KEY INGREDIENT FOR INVESTORS TO MAKE GOOD DECISIONS. FINALLY, WE DEFINE AN EXTENDED VERSION OF THE MARTINGALE CONDITION, DEFINED FOR THE GAUGE HAMILTONIAN.