Option pricing with state‐dependent pricing kernel

We introduce a new volatility model for option pricing that combines Markov switching with the realized generalized autoregressive conditional heteroskedasticity (GARCH) framework. This leads to a novel pricing kernel with a state‐dependent variance risk premium and a pricing formula for European options, which is derived with an analytical approximation method. We apply the Markov‐switching Realized GARCH model to Standard and Poor's 500 index options from 1990 to 2019 and find that investors' aversion to volatility‐specific risk is time‐varying. The proposed framework outperforms competing models and reduces (in‐sample and out‐of‐sample) option‐pricing errors by 15% or more.