Pitfalls in VAR Based Return Decompositions: A Clarification

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 explain 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. Finally, we clarify the intriguing issue of the role of the residual component in return decompositions. In a properly specified VAR, it makes no difference whether return news and cash flow news are both computed directly or one of them is backed out as a residual.

Keywords: Return variance decomposition, news components, VAR model, information set, predictive variables, redundant models

JEL Classification: C32, G12, G17