Option Pricing with Time-Varying Volatility Risk Aversion

Peter Hansen and Chen Tong

Papers from arXiv.org

Abstract: We introduce a pricing kernel with time-varying volatility risk aversion to explain 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.

Date: 2022-04, Revised 2025-03
New Economics Papers: this item is included in nep-ore, nep-rmg and nep-upt
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Citations: View citations in EconPapers (2)

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