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Pitfalls in VAR based return decompositions: A clarification

Listed author(s):
  • 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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File URL: ftp://ftp.econ.au.dk/creates/rp/10/rp10_09.pdf
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Paper provided by Department of Economics and Business Economics, Aarhus University in its series CREATES Research Papers with number 2010-09.

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Length: 28
Date of creation: 01 Feb 2010
Handle: RePEc:aah:create:2010-09
Contact details of provider: Web page: http://www.econ.au.dk/afn/

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  1. 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.
  2. Ben S. Bernanke & Kenneth N. Kuttner, 2003. "What explains the stock market's reaction to Federal Reserve policy?," Proceedings, Federal Reserve Bank of San Francisco, issue Mar, pages -.
  3. Engsted, Tom & Pedersen, Thomas Q., 2010. "The dividend-price ratio does predict dividend growth: International evidence," Journal of Empirical Finance, Elsevier, vol. 17(4), pages 585-605, September.
  4. Campbell, John Y, 1991. "A Variance Decomposition for Stock Returns," Economic Journal, Royal Economic Society, vol. 101(405), pages 157-179, March.
  5. 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.
  6. 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.
  7. 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.
  8. 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.
  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. Long Chen & Xinlei Zhao, 2009. "Return Decomposition," Review of Financial Studies, Society for Financial Studies, vol. 22(12), pages 5213-5249, December.
  11. Campbell, John Y & Shiller, Robert J, 1988. " Stock Prices, Earnings, and Expected Dividends," Journal of Finance, American Finance Association, vol. 43(3), pages 661-676, July.
  12. John Y. Campbell & Tuomo Vuolteenaho, 2004. "Bad Beta, Good Beta," American Economic Review, American Economic Association, vol. 94(5), pages 1249-1275, December.
  13. 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.
  14. 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.
  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. 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.
  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 421-436, June.
  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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