Arbitrage pricing with incomplete markets

This paper presents a new arbitrage-free approach to the pricing of derivatives, when the price process of the underlying security does not conform to the standard assumptions. In comparision to the Black-Scholes price process we relax the requirements of i) continuity; ii) constant volatility; and iii) infinite trading possibilities. We retain the assumption that the average volatility of price changes over the option's life is known, and we require that price jumps not be greater than some specified size. With only these assumptions we show that the no-arbitrage bound on a European call option's value approaches the Black-Scholes price as the maximum jump size approaches zero. We present a simple numerical method for the calculation of option pricing bounds for any specified maximum jump size, and discuss implications of our model for hedging, and the estimation of volatility.