Return Decomposition

Posted: 7 Sep 2008

See all articles by Long Chen

Long Chen

Luohan Academy; Cheung Kong Graduate School of Business

Xinlei Shelly Zhao

Government of the United States of America - Office of the Currency Comptroller - Risk Analysis Division

Multiple version iconThere are 3 versions of this paper

Date Written: September 5, 2008

Abstract

A crucial issue in asset pricing is to understand the relative importance of discount rate (DR) news and cash flow (CF) news in driving the time-series and cross-sectional variations of stock returns. Many studies directly estimate the DR news but back out the CF news as the residual. We argue that this approach has a serious limitation because the DR news cannot be accurately measured due to the small predictive power, and the CF news, as the residual, inherits the large misspecification error of the DR news. We apply this residual-based decomposition approach to Treasury bonds and equities, and find results that are either counter-intuitive or unrobust. Potential solutions, including modeling both DR news and CF news directly, the Bayesian model averaging approach, and the principal component analysis, are explored.

Keywords: return decomposition, discount rate, cash flow, value stock, growth stock

JEL Classification: G11, G12

Suggested Citation

Chen, Long and Zhao, Xinlei, Return Decomposition (September 5, 2008). Review of Financial Studies, Forthcoming. Available at SSRN: https://ssrn.com/abstract=1263976

Long Chen (Contact Author)

Luohan Academy ( email )

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Hangzhou, Zhejiang 310013
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+86-0571-2688-8888-75520 (Phone)

Cheung Kong Graduate School of Business ( email )

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One East Chang An Avenue
Beijing, 100738
China

Xinlei Zhao

Government of the United States of America - Office of the Currency Comptroller - Risk Analysis Division ( email )

250 E Street, SW
Washington, DC 20219
United States

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