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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. 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.
  2. 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.
  3. 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.
  4. Lewellen, Jonathan, 2004. "Predicting returns with financial ratios," Journal of Financial Economics, Elsevier, vol. 74(2), pages 209-235, November.
  5. Campbell, John & Yogo, Motohiro, 2006. "Efficient tests of stock return predictability," Scholarly Articles 3122601, Harvard University Department of Economics.
  6. 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.
  7. 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.
  8. Campbell, John & Shiller, Robert, 1988. "Stock Prices, Earnings, and Expected Dividends," Scholarly Articles 3224293, Harvard University Department of Economics.
  9. 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.
  10. 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.
  11. 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.
  12. 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.
  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. 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.
  15. John Y. Campbell & Tuomo Vuolteenaho, 2002. "Bad Beta, Good Beta," Harvard Institute of Economic Research Working Papers 1971, Harvard - Institute of Economic Research.
  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. John Y. Campbell, 1990. "A Variance Decomposition for Stock Returns," NBER Working Papers 3246, National Bureau of Economic Research, Inc.
  18. 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.
  19. Long Chen & Xinlei Zhao, 2009. "Return Decomposition," Review of Financial Studies, Society for Financial Studies, vol. 22(12), pages 5213-5249, December.
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