Journal
JOURNAL OF FINANCIAL ECONOMICS
Volume 72, Issue 2, Pages 291-318Publisher
ELSEVIER SCIENCE SA
DOI: 10.1016/j.jfineco.2003.02.001
Keywords
implied volatility functions; valuation errors; out-of-sample forecasting; parameter stability
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Which loss function should be used when estimating and evaluating option valuation models? Many different functions have been suggested, but no standard has emerged. We emphasize that consistency in the choice of loss functions is crucial. First, for any given model, the loss function used in parameter estimation and model evaluation should be the same, otherwise suboptimal parameter estimates may be obtained. Second, when comparing models, the estimation loss function should be identical across models, otherwise inappropriate comparisons will be made. We illustrate the importance of these issues in an application of the so-called Practitioner Black-Scholes model to S&P 500 index options. (C) 2003 Elsevier B.V. All rights reserved.
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