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Pitfalls in VAR based return decompositions: A clarification

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  • 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, 1991. "A Variance Decomposition for Stock Returns," Scholarly Articles 3207695, Harvard University Department of Economics.
  2. Borja Larrain & Motohiro Yogo, 2005. "Does firm value move too much to be justified by subsequent changes in cash flow?," Working Papers, Federal Reserve Bank of Boston 05-18, Federal Reserve Bank of Boston.
  3. 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.
  4. Campbell, John & Vuolteenaho, Tuomo, 2004. "Bad Beta, Good Beta," Scholarly Articles 3122489, Harvard University Department of Economics.
  5. John H. Cochrane, 2008. "The Dog That Did Not Bark: A Defense of Return Predictability," Review of Financial Studies, Society for Financial Studies, Society for Financial Studies, vol. 21(4), pages 1533-1575, July.
  6. Robert J. Shiller & John Y. Campbell, 1986. "The Dividend-Price Ratio and Expectations of Future Dividends and Discount Factors," Cowles Foundation Discussion Papers, Cowles Foundation for Research in Economics, Yale University 812, Cowles Foundation for Research in Economics, Yale University.
  7. John Y. Campbell & Christopher Polk & Tuomo Vuolteenaho, 2005. "Growth or Glamour? Fundamentals and Systematic Risk in Stock Returns," Harvard Institute of Economic Research Working Papers, Harvard - Institute of Economic Research 2082, Harvard - Institute of Economic Research.
  8. Campbell, J.Y. & Shiller, R.J., 1988. "Stock Prices, Earnings And Expected Dividends," Papers, Princeton, Department of Economics - Econometric Research Program 334, Princeton, Department of Economics - Econometric Research Program.
  9. John Y. Campbell & John Ammer, 1991. "What Moves the Stock and Bond Markets? A Variance Decomposition for Long-Term Asset Returns," NBER Working Papers 3760, National Bureau of Economic Research, Inc.
  10. Shiller, Robert J, 1981. "Do Stock Prices Move Too Much to be Justified by Subsequent Changes in Dividends?," American Economic Review, American Economic Association, American Economic Association, vol. 71(3), pages 421-36, June.
  11. John Y. Campbell & Motohiro Yogo, 2003. "Efficient Tests of Stock Return Predictability," NBER Working Papers 10026, National Bureau of Economic Research, Inc.
  12. Ben Bernanke & Kenneth N. Kuttner, 2003. "What explains the stock market's reaction to Federal Reserve policy?," Proceedings, Federal Reserve Bank of San Francisco, Federal Reserve Bank of San Francisco, issue Mar.
  13. Tom Engsted & Carsten Tanggaard, 2004. "The Comovement of US and UK Stock Markets," European Financial Management, European Financial Management Association, European Financial Management Association, vol. 10(4), pages 593-607.
  14. Tom Engsted & Thomas Q. Pedersen, 2009. "The dividend-price ratio does predict dividend growth: International evidence," CREATES Research Papers, School of Economics and Management, University of Aarhus 2009-36, School of Economics and Management, University of Aarhus.
  15. Fama, Eugene F. & French, Kenneth R., 1988. "Dividend yields and expected stock returns," Journal of Financial Economics, Elsevier, Elsevier, vol. 22(1), pages 3-25, October.
  16. Chen, Long, 2009. "On the reversal of return and dividend growth predictability: A tale of two periods," Journal of Financial Economics, Elsevier, Elsevier, vol. 92(1), pages 128-151, April.
  17. Lewellen, Jonathan, 2004. "Predicting returns with financial ratios," Journal of Financial Economics, Elsevier, Elsevier, vol. 74(2), pages 209-235, November.
  18. Ammer, John & Mei, Jianping, 1996. " Measuring International Economic Linkages with Stock Market Data," Journal of Finance, American Finance Association, American Finance Association, vol. 51(5), pages 1743-63, December.
  19. Long Chen & Xinlei Zhao, 2009. "Return Decomposition," Review of Financial Studies, Society for Financial Studies, Society for Financial Studies, vol. 22(12), pages 5213-5249, December.
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Cited by:
  1. Campbell, John Y. & Giglio, Stefano & Polk, Christopher, 2013. "Hard Times," Scholarly Articles 12172786, Harvard University Department of Economics.
  2. Robert J. Shiller, 2014. "Speculative Asset Prices," American Economic Review, American Economic Association, American Economic Association, vol. 104(6), pages 1486-1517, June.
  3. Tom Engsted & Thomas Q. Pedersen, 2013. "Housing market volatility in the OECD area: Evidence from VAR based return decompositions," CREATES Research Papers, School of Economics and Management, University of Aarhus 2013-04, School of Economics and Management, University of Aarhus.
  4. Mahmoud Botshekan & Roman Kraeussl & Andre Lucas, 2010. "Cash Flow and Discount Rate Risk in Up and Down Markets: What is actually priced?," Tinbergen Institute Discussion Papers, Tinbergen Institute 10-116/2/DSF 3, Tinbergen Institute.
  5. Chortareas, Georgios & Noikokyris, Emmanouil, 2014. "Oil shocks, stock market prices, and the U.S. dividend yield decomposition," International Review of Economics & Finance, Elsevier, Elsevier, vol. 29(C), pages 639-649.
  6. Galsband, Victoria, 2012. "Downside risk of international stock returns," Journal of Banking & Finance, Elsevier, Elsevier, vol. 36(8), pages 2379-2388.
  7. 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.
  8. 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.
  9. Acker, Daniella & Duck, Nigel W., 2013. "Inflation illusion and the US dividend yield: Some further evidence," Journal of International Money and Finance, Elsevier, Elsevier, vol. 33(C), pages 235-254.
  10. 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.

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