Option Pricing with Time-Varying Volatility Risk Aversion
Pricing of Securities
2025-03-11 v4 Econometrics
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.
Cite
@article{arxiv.2204.06943,
title = {Option Pricing with Time-Varying Volatility Risk Aversion},
author = {Peter Reinhard Hansen and Chen Tong},
journal= {arXiv preprint arXiv:2204.06943},
year = {2025}
}