Option Pricing with Time-Varying Volatility Risk Aversion

Peter Reinhard Hansen and Chen Tong

The Review of Financial Studies, 2026, vol. 39, issue 3, 875-924

Abstract: We introduce a pricing kernel with time-varying volatility risk aversion to explain the observed time variations in the shape of the pricing kernel. When combined with the Heston-Nandi GARCH model, this framework yields a tractable option pricing model in which the variance risk ratio (VRR) emerges as a key variable. We show that the VRR is closely linked to economic fundamentals, as well as sentiment and uncertainty measures. A novel approximation method provides analytical option pricing formulas, and we demonstrate substantial reductions in pricing errors through an empirical application to the S&P 500 index, the CBOE VIX, and option prices.

Keywords: G12; G13; C51; C52 (search for similar items in EconPapers)
Date: 2026
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