The Resource-Constrained Bayesian Brain and Option Pricing

In the brain sciences, an influential paradigm is that the brain is a Bayesian prediction engine operating under a resource constraint. We study the implications of this view for option pricing. We show that this brain-based view leads to higher no-arbitrage prices than what the traditional models suggest with the largest impact on the prices of far out-of-the-money puts. The approach is equivalent to replacing the risk-free rate with a higher-rate in the call option formula, and makes several granular predictions about option-returns and implied volatility skew. We illustrate the improvement in model-fit by calibrating with S&P 500 index- options