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Pitfalls in VAR based return decompositions: A clarification

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Author Info

  • Tom Engsted

    ()
    (CREATES, University of Aarhus, Building 1326, DK-8000 Aarhus C)

  • Thomas Q. Pedersen

    ()
    (CREATES, University of Aarhus, Building 1326, DK-8000 Aarhus C)

  • Carsten Tanggaard

    ()
    (CREATES, University of Aarhus, Building 1326, DK-8000 Aarhus C)

Abstract

Based on Chen and Zhao's (2009) criticism of VAR based return de- compositions, we explain in detail the various limitations and pitfalls involved in such decompositions. First, we show that Chen and Zhao's interpretation of their excess bond return decomposition is wrong: the residual component in their analysis is not "cashflow news" but "inter- est rate news" which should not be zero. Consequently, in contrast to what Chen and Zhao claim, their decomposition does not serve as a valid caution against VAR based decompositions. Second, we point out that in order for VAR based decompositions to be valid, the asset price needs to be included as a state variable. In parts of Chen and Zhao's analysis the price does not appear as a state variable, thus rendering those parts of their analysis invalid. Finally, we clarify the intriguing issue of the role of the residual component in equity return decompositions. In a properly specified VAR, it makes no difference whether return news and dividend news are both computed directly or one of them is backed out as a residual.

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Bibliographic Info

Paper provided by School of Economics and Management, University of Aarhus in its series CREATES Research Papers with number 2010-09.

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Length: 28
Date of creation: 01 Feb 2010
Date of revision:
Handle: RePEc:aah:create:2010-09

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Web page: http://www.econ.au.dk/afn/

Related research

Keywords: Return variance decomposition; news components; VAR model; information set; predictive variables; redundant models;

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  1. Campbell, John & Vuolteenaho, Tuomo, 2004. "Bad Beta, Good Beta," Scholarly Articles 3122489, Harvard University Department of Economics.
  2. Campbell, John & Shiller, Robert, 1988. "Stock Prices, Earnings, and Expected Dividends," Scholarly Articles 3224293, Harvard University Department of Economics.
  3. Campbell, John & Yogo, Motohiro, 2006. "Efficient tests of stock return predictability," Scholarly Articles 3122601, Harvard University Department of Economics.
  4. Larrain, Borja & Yogo, Motohiro, 2008. "Does firm value move too much to be justified by subsequent changes in cash flow," Journal of Financial Economics, Elsevier, vol. 87(1), pages 200-226, January.
  5. Campbell, J.Y. & Ammer, J., 1991. "What Moves The Stock And Bond Markets? A Variance Decomposition For Long- Term Asset Returns," Papers 127, Princeton, Department of Economics - Financial Research Center.
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  7. Robert J. Shiller, 1980. "Do Stock Prices Move Too Much to be Justified by Subsequent Changes in Dividends?," NBER Working Papers 0456, National Bureau of Economic Research, Inc.
  8. Chen, Long, 2009. "On the reversal of return and dividend growth predictability: A tale of two periods," Journal of Financial Economics, Elsevier, vol. 92(1), pages 128-151, April.
  9. Tom Engsted & Thomas Q. Pedersen, 2009. "The dividend-price ratio does predict dividend growth: International evidence," CREATES Research Papers 2009-36, School of Economics and Management, University of Aarhus.
  10. Engsted, Tom & Tanggaard, Carsten, 2002. "The comovement of US and UK stock markets," Finance Working Papers 02-1, University of Aarhus, Aarhus School of Business, Department of Business Studies.
  11. John H. Cochrane, 2006. "The Dog That Did Not Bark: A Defense of Return Predictability," NBER Working Papers 12026, National Bureau of Economic Research, Inc.
  12. Ben S. Bernanke & Kenneth N. Kuttner, 2003. "What explains the stock market's reaction to Federal Reserve policy?," Staff Reports 174, Federal Reserve Bank of New York.
  13. John Y. Campbell, Robert J. Shiller, 1988. "The Dividend-Price Ratio and Expectations of Future Dividends and Discount Factors," Review of Financial Studies, Society for Financial Studies, vol. 1(3), pages 195-228.
  14. John Campbell & Jianping Mei, 1993. "Where do Betas Come From? Asset Price Dynamics and the Sources of Systematic Risk," NBER Working Papers 4329, National Bureau of Economic Research, Inc.
  15. John Y. Campbell & Christopher Polk & Tuomo Vuolteenaho, 2005. "Growth or Glamour? Fundamentals and Systematic Risk in Stock Returns," NBER Working Papers 11389, National Bureau of Economic Research, Inc.
  16. Polk, Christopher & Vuolteenaho, Tuomo & Campbell, John Y., 2010. "Growth or Glamour? Fundamentals and Systematic Risk in Stock Returns," Scholarly Articles 9887622, Harvard University Department of Economics.
  17. Long Chen & Xinlei Zhao, 2009. "Return Decomposition," Review of Financial Studies, Society for Financial Studies, vol. 22(12), pages 5213-5249, December.
  18. Ammer, John & Mei, Jianping, 1996. " Measuring International Economic Linkages with Stock Market Data," Journal of Finance, American Finance Association, vol. 51(5), pages 1743-63, December.
  19. Lewellen, Jonathan, 2004. "Predicting returns with financial ratios," Journal of Financial Economics, Elsevier, vol. 74(2), pages 209-235, November.
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Citations

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Cited by:
  1. Tom Engsted & Thomas Q. Pedersen, 2013. "Housing market volatility in the OECD area: Evidence from VAR based return decompositions," CREATES Research Papers 2013-04, School of Economics and Management, University of Aarhus.
  2. Botshekan, Mahmoud & Kraeussl, Roman & Lucas, Andre, 2012. "Cash Flow and Discount Rate Risk in Up and Down Markets: What Is Actually Priced?," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 47(06), pages 1279-1301, December.
  3. Thomas Nitschka, 2014. "The Good? The Bad? The Ugly? Which news drive (co)variation in Swiss and US bond and stock excess returns?," Working Papers 2014-01, Swiss National Bank.
  4. John Y. Campbell & Stefano Giglio & Christopher Polk, 2010. "Hard Times," NBER Working Papers 16222, National Bureau of Economic Research, Inc.
  5. Chortareas, Georgios & Noikokyris, Emmanouil, 2014. "Oil shocks, stock market prices, and the U.S. dividend yield decomposition," International Review of Economics & Finance, Elsevier, vol. 29(C), pages 639-649.
  6. Hans Haller & Ming Yi, 2013. "Paths of a Continuum of Independent Random Variables," Working Papers e07-44, Virginia Polytechnic Institute and State University, Department of Economics.
  7. Campbell, John Y. & Giglio, Stefano & Polk, Christopher, 2013. "Hard Times," Scholarly Articles 12172786, Harvard University Department of Economics.
  8. Acker, Daniella & Duck, Nigel W., 2013. "Inflation illusion and the US dividend yield: Some further evidence," Journal of International Money and Finance, Elsevier, vol. 33(C), pages 235-254.
  9. Guillén, Montserrat & Sarabia, José María & Prieto, Faustino, 2013. "Simple risk measure calculations for sums of positive random variables," Insurance: Mathematics and Economics, Elsevier, vol. 53(1), pages 273-280.
  10. Robert J. Shiller, 2014. "Speculative Asset Prices," American Economic Review, American Economic Association, vol. 104(6), pages 1486-1517, June.
  11. Galsband, Victoria, 2012. "Downside risk of international stock returns," Journal of Banking & Finance, Elsevier, vol. 36(8), pages 2379-2388.

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