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Pitfalls in VAR based return decompositions: A clarification
Om AU
Tom Engsted
Pitfalls in VAR based return decompositions: A clarification
Publikation: Working paper › Forskning
Dokumenter
- Rp10 09
Forlagets udgivne version, 251 KB, PDF-dokument
- Institut for Økonomi - CREATES
- Institut for Økonomi
- Erhvervsøkonomisk Institut
- Finance Research Group
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.
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.
| Originalsprog | Engelsk |
|---|---|
| Udgivelsessted | Aarhus |
| Udgiver | Institut for Økonomi, Aarhus Universitet |
| Antal sider | 30 |
| Status | Udgivet - 2010 |
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