A modified Black-Scholes pricing formula for European options with bounded underlying prices

In this paper, a modified Black-Scholes (B-S) model is proposed, based on a revised assumption that the range of the underlying price varies within a finite zone, rather than being allowed to vary in a semi-infinite zone as presented in the classical B-S theory. This is motivated by the fact that the underlying price of any option can never reach infinity in reality; a trader may use our new formula to adjust the option price that he/she is willing to long or short. To develop this modified option pricing formula, we assume that a trader has a view on the realistic price range of a particular asset and the log-returns follow a truncated normal distribution within this price range. After a closed-form pricing formula for European call options has been successfully derived, some numerical experiments are conducted. To further demonstrate the meaning of the proposed model, empirical studies are carried out to compare the pricing performance of our model and that of the B-S model with real market data. (C) 2017 Elsevier Ltd. All rights reserved.