Option Pricing with Time-Varying Volatility Risk Aversion

Peter Reinhard Hansen; Chen Tong

doi:10.1093/rfs/hhaf063

Option Pricing with Time-Varying Volatility Risk Aversion

Peter Reinhard Hansen¹; Chen Tong²

¹ University of North Carolina at Chapel Hill · ² School of Economics and Wang Yanan Institute for Studies in Economics, Xiamen University ,

Review of Financial Studies 2026

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.

DOI: 10.1093/rfs/hhaf063
Volume: 39 (3)
Pages: 875-924
Language: en
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