A Bayesian analysis of a variance decomposition for stock returns

Hollifield, B. and Koop, G.M. and Li, K. (2003) A Bayesian analysis of a variance decomposition for stock returns. Journal of Empirical Finance, 10 (5). pp. 583-601. ISSN 0927-5398 (http://dx.doi.org/10.1016/S0927-5398(03)00006-9)

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Abstract

We apply Bayesian methods to study a common vector autoregression (VAR)-based approach for decomposing the variance of excess stock returns into components reflecting news about future excess stock returns, future real interest rates, and future dividends. We develop a new prior elicitation strategy, which involves expressing beliefs about the components of the variance decomposition. Previous Bayesian work elicited priors from the difficult-to-interpret parameters of the VAR. With a commonly used data set, we find that the posterior standard deviations for the variance decomposition based on these previously used priors, including ''non-informative'' limiting cases, are much larger than classical standard errors based on asymptotic approximations. Therefore, the non-informative researcher remains relatively uninformed about the variance decomposition after observing the data. We show the large posterior standard deviations arise because the ''non-informative'' prior is implicitly very informative in a highly undesirable way. However, reasonably informative priors using our elicitation method allow for much more precise inference about components of the variance decomposition.

ORCID iDs

Hollifield, B., Koop, G.M. ORCID logoORCID: https://orcid.org/0000-0002-6091-378X and Li, K.;
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