IDEAS home Printed from https://ideas.repec.org/
MyIDEAS: Login to save this article or follow this journal

Pitfalls in VAR based return decompositions: A clarification

  • Engsted, Tom
  • Pedersen, Thomas Q.
  • Tanggaard, Carsten

We analyze the pitfalls involved in VAR based return decompositions. First, we show that recent criticism of such decompositions is misplaced and builds on invalid VAR models and erroneous interpretations. Second, we derive the requirements needed for VAR decompositions to be valid. A crucial – but often neglected – requirement is that the asset price needs to be included as a state variable in the VAR. In equity return decompositions this requirement is equivalent to including the dividend–price ratio in the VAR. Finally, we clarify the intriguing issue of the role of the residual component in return decompositions. In a properly specified first-order VAR, it makes no difference whether cash flow news or discount rate news is backed out residually, and it makes no difference whether both news components are computed directly or one of them is backed out residually.

If you experience problems downloading a file, check if you have the proper application to view it first. In case of further problems read the IDEAS help page. Note that these files are not on the IDEAS site. Please be patient as the files may be large.

File URL: http://www.sciencedirect.com/science/article/pii/S0378426611003153
Download Restriction: Full text for ScienceDirect subscribers only

As the access to this document is restricted, you may want to look for a different version under "Related research" (further below) or search for a different version of it.

Article provided by Elsevier in its journal Journal of Banking & Finance.

Volume (Year): 36 (2012)
Issue (Month): 5 ()
Pages: 1255-1265

as
in new window

Handle: RePEc:eee:jbfina:v:36:y:2012:i:5:p:1255-1265
Contact details of provider: Web page: http://www.elsevier.com/locate/jbf

References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:

as in new window
  1. Fama, Eugene F. & French, Kenneth R., 1988. "Dividend yields and expected stock returns," Journal of Financial Economics, Elsevier, vol. 22(1), pages 3-25, October.
  2. Robert J. Shiller & John Y. Campbell, 1986. "The Dividend-Price Ratio and Expectations of Future Dividends and Discount Factors," Cowles Foundation Discussion Papers 812, Cowles Foundation for Research in Economics, Yale University.
  3. Ben S. Bernanke & Kenneth N. Kuttner, 2004. "What Explains the Stock Market's Reaction to Federal Reserve Policy?," NBER Working Papers 10402, National Bureau of Economic Research, Inc.
  4. Campbell, John, 1991. "A Variance Decomposition for Stock Returns," Scholarly Articles 3207695, Harvard University Department of Economics.
  5. John Y. Campbell & Tuomo Vuolteenaho, 2003. "Bad Beta, Good Beta," Harvard Institute of Economic Research Working Papers 2016, Harvard - Institute of Economic Research.
  6. Ammer, John & Campbell, John, 1993. "What Moves the Stock and Bond Markets? A Variance Decomposition for Long-Term Asset Returns," Scholarly Articles 3382857, Harvard University Department of Economics.
  7. Campbell, John Y. & Yogo, Motohiro, 2006. "Efficient tests of stock return predictability," Journal of Financial Economics, Elsevier, vol. 81(1), pages 27-60, July.
  8. 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.
  9. Campbell, John Y. & Mei, Jianping, 1993. "Where Do Betas Come From? Asset Price Dynamics and the Sources of Systematic Risk," Scholarly Articles 3353757, Harvard University Department of Economics.
  10. Campbell, John & Shiller, Robert, 1988. "Stock Prices, Earnings, and Expected Dividends," Scholarly Articles 3224293, Harvard University Department of Economics.
  11. Borja Larrain & Motohiro Yogo, 2005. "Does firm value move too much to be justified by subsequent changes in cash flow?," Working Papers 05-18, Federal Reserve Bank of Boston.
  12. Lewellen, Jonathan, 2004. "Predicting returns with financial ratios," Journal of Financial Economics, Elsevier, vol. 74(2), pages 209-235, November.
  13. 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 2082, Harvard - Institute of Economic Research.
  14. 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.
  15. John Ammer & Jianping Mei, 1993. "Measuring international economic linkages with stock market data," International Finance Discussion Papers 449, Board of Governors of the Federal Reserve System (U.S.).
  16. 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.
  17. Shiller, Robert J, 1981. "Do Stock Prices Move Too Much to be Justified by Subsequent Changes in Dividends?," American Economic Review, American Economic Association, vol. 71(3), pages 421-36, June.
  18. Long Chen & Xinlei Zhao, 2009. "Return Decomposition," Review of Financial Studies, Society for Financial Studies, vol. 22(12), pages 5213-5249, December.
  19. 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.
Full references (including those not matched with items on IDEAS)

This item is not listed on Wikipedia, on a reading list or among the top items on IDEAS.

When requesting a correction, please mention this item's handle: RePEc:eee:jbfina:v:36:y:2012:i:5:p:1255-1265. See general information about how to correct material in RePEc.

For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Zhang, Lei)

If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

If references are entirely missing, you can add them using this form.

If the full references list an item that is present in RePEc, but the system did not link to it, you can help with this form.

If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your profile, as there may be some citations waiting for confirmation.

Please note that corrections may take a couple of weeks to filter through the various RePEc services.

This information is provided to you by IDEAS at the Research Division of the Federal Reserve Bank of St. Louis using RePEc data.