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Option Pricing with Time-Varying Volatility Risk Aversion

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  • Peter Reinhard Hansen
  • Chen Tong
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.

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  • Peter Reinhard Hansen & Chen Tong, 2022. "Option Pricing with Time-Varying Volatility Risk Aversion," Papers 2204.06943, arXiv.org, revised Aug 2024.
    • Handle: RePEc:arx:papers:2204.06943
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    2. Wu, Xinyu & Zhao, An & Liu, Li, 2023. "Forecasting VIX using two-component realized EGARCH model," The North American Journal of Economics and Finance, Elsevier, vol. 67(C).

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