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 that can explain the observed time variation in the shape of the pricing kernel. Dynamic volatility risk aversion, combined with the Heston-Nandi GARCH model, leads to a convenient option pricing model, denoted DHNG. The variance risk ratio emerges as a fundamental variable, and we show that it is closely related to economic fundamentals and common measures of sentiment and uncertainty. DHNG yields a closed-form pricing formula for the VIX, and we propose a novel approximation method that provides analytical expressions for option prices. We estimate the model using S&P 500 returns, the VIX, and option prices, and find that dynamic volatility risk aversion leads to a substantial reduction in VIX and option pricing errors.

Date: 2022-04, Revised 2024-08
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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