Pitfalls in VAR based return decompositions: A clarification

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.

► We show that recent criticism of VAR based return decompositions is misplaced. ► We derive the requirements needed for VAR decompositions to be valid. ► We clarify the exact role of the residual component in return decompositions.