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Pitfalls in VAR based return decompositions: A clarification

  • 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)

Based on Chen and Zhao's (2009) criticism of VAR based return decompositions, 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 "interest 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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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
Contact details of provider: Web page: http://www.econ.au.dk/afn/

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  1. John Y. Campbell & Robert J. Shiller, 1988. "Stock Prices, Earnings and Expected Dividends," Cowles Foundation Discussion Papers 858, Cowles Foundation for Research in Economics, Yale University.
  2. John Y. Campbell & Robert J. Shiller, 1986. "The Dividend-Price Ratio and Expectations of Future Dividends and Discount Factors," NBER Working Papers 2100, National Bureau of Economic Research, Inc.
  3. 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.
  4. 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.
  5. John Y. Campbell & Tuomo Vuolteenaho, 2004. "Bad Beta, Good Beta," American Economic Review, American Economic Association, vol. 94(5), pages 1249-1275, December.
  6. John Y. Campbell, 1990. "A Variance Decomposition for Stock Returns," NBER Working Papers 3246, National Bureau of Economic Research, Inc.
  7. John Y. Campbell & Christopher Polk & Tuomo Vuolteenaho, 2010. "Growth or Glamour? Fundamentals and Systematic Risk in Stock Returns," Review of Financial Studies, Society for Financial Studies, vol. 23(1), pages 305-344, January.
  8. 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.
  9. Borja Larrain & Motohiro Yogo, 2007. "Does Firm Value Move Too Much to be Justified by Subsequent Changes in Cash Flow?," NBER Working Papers 12847, National Bureau of Economic Research, Inc.
  10. John H. Cochrane, 2008. "The Dog That Did Not Bark: A Defense of Return Predictability," Review of Financial Studies, Society for Financial Studies, vol. 21(4), pages 1533-1575, July.
  11. 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.
  12. John Y. Campbell & Motohiro Yogo, 2002. "Efficient Tests of Stock Return Predictability," Harvard Institute of Economic Research Working Papers 1972, Harvard - Institute of Economic Research.
  13. 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.
  14. 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.
  15. Long Chen & Xinlei Zhao, 2009. "Return Decomposition," Review of Financial Studies, Society for Financial Studies, vol. 22(12), pages 5213-5249, December.
  16. 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.
  17. Tom Engsted & Carsten Tanggaard, 2004. "The Comovement of US and UK Stock Markets," European Financial Management, European Financial Management Association, vol. 10(4), pages 593-607.
  18. Lewellen, Jonathan, 2004. "Predicting returns with financial ratios," Journal of Financial Economics, Elsevier, vol. 74(2), pages 209-235, November.
  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.
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