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Pitfalls in VAR based return decompositions: A clarification

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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.
Original languageEnglish
Place of publicationAarhus
PublisherInstitut for Økonomi, Aarhus Universitet
Number of pages30
Publication statusPublished - 2010

    Research areas

  • Return variance decomposition, news components, VAR model, information set, predictive variables, redundant models.

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