Pitfalls in VAR based return decompositions: A clarification

Tom Engsted, Thomas Pedersen () and Carsten Tanggaard

Journal of Banking & Finance, 2012, vol. 36, issue 5, 1255-1265

Abstract: We analyze the pitfalls involved in VAR based return decompositions. First, we show that recent criticism of such decompositions is misplaced and builds on invalid VAR models and erroneous interpretations. Second, we derive the requirements needed for VAR decompositions to be valid. A crucial – but often neglected – requirement is that the asset price needs to be included as a state variable in the VAR. In equity return decompositions this requirement is equivalent to including the dividend–price ratio in the VAR. Finally, we clarify the intriguing issue of the role of the residual component in return decompositions. In a properly specified first-order VAR, it makes no difference whether cash flow news or discount rate news is backed out residually, and it makes no difference whether both news components are computed directly or one of them is backed out residually.

Keywords: Return variance decomposition; News components; VAR model; Information set; Predictive variables; Redundant models (search for similar items in EconPapers)
JEL-codes: C32 G12 G17 (search for similar items in EconPapers)
Date: 2012
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (62)

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Working Paper: Pitfalls in VAR based return decompositions: A clarification (2010)
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Persistent link: https://EconPapers.repec.org/RePEc:eee:jbfina:v:36:y:2012:i:5:p:1255-1265

DOI: 10.1016/j.jbankfin.2011.11.004

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