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Option Pricing with Time-Varying Volatility Risk Aversion

Author

Listed:
  • Peter Reinhard Hansen
  • Chen Tong

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.

Suggested Citation

  • Peter Reinhard Hansen & Chen Tong, 2026. "Option Pricing with Time-Varying Volatility Risk Aversion," The Review of Financial Studies, Society for Financial Studies, vol. 39(3), pages 875-924.
    • Handle: RePEc:oup:rfinst:v:39:y:2026:i:3:p:875-924.
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    File URL: http://hdl.handle.net/10.1093/rfs/hhaf063
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    Keywords

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    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
    • C51 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Model Construction and Estimation
    • C52 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Model Evaluation, Validation, and Selection

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