Valuation of European options in the market with daily price limit

A valuation problem of the European style contingent claim in the market with daily price movement limit is studied. Unlike the one leading to the well known Black-Scholes formula, this problem depicts considerable conceptual difficulty and anomaly created by the presence of various arbitrage opportunities inherently built in the model due to the daily price movement limit. The presence of arbitrage makes it go against the grain of the well established arbitrage pricing theory. In this paper, how these complications arise are discussed and then a valuation approach devised, which is called the ‘vanishing transaction cost technique,’ of getting around the difficulty.