Credit Rating

We survey 392 CFOs about the cost of capital, capital budgeting, and capital structure. Large "rms rely heavily on present value techniques and the capital asset pricing model, while small "rms are relatively likely to use the payback criterion. A surprising number of "rms use "rm risk rather than project risk in evaluating new investments. Firms are concerned about "nancial #exibility and credit ratings when issuing debt, and earnings ଝ We thank Franklin Allen for his detailed comments on the survey instrument and the overall project. We appreciate the input of (C.R. Harvey).

A company's credit default swap spread is the cost per annum for protection against a default by the company. In this paper we analyze data on credit default swap spreads collected by a credit derivatives broker. We first examine the relationship between credit default spreads and bond yields and reach conclusions on the benchmark risk-free rate used by participants in the credit derivatives market. We then carry out a series of tests to explore the extent to which credit rating announcements by Moody's are anticipated by participants in the credit default swap market.

Corporate credit rating analysis has attracted lots of research interests in the literature. Recent studies have shown that Artificial Intelligence (AI) methods achieved better performance than traditional statistical methods. This article introduces a relatively new machine learning technique, support vector machines (SVM), to the problem in attempt to provide a model with better explanatory power. We used backpropagation neural network (BNN) as a benchmark and obtained prediction accuracy around 80% for both BNN and SVM methods for the United States and Taiwan markets. However, only slight improvement of SVM was observed. Another direction of the research is to improve the interpretability of the AI-based models. We applied recent research results in neural network model interpretation and obtained relative importance of the input financial variables from the neural network models. Based on these results, we conducted a market comparative analysis on the differences of determining factors in the United States and Taiwan markets.

n recent years, the demand for sovereign credit ratings-the risk assessments assigned by the credit rating agencies to the obligations of central governments-has increased dramatically. More governments with greater default risk and more companies domiciled in riskier host countries are borrowing in international bond markets. Although foreign government officials generally cooperate with the agencies, rating assignments that are lower than anticipated often prompt issuers to question the consistency and rationale of sovereign ratings. How clear are the criteria underlying sovereign ratings? Moreover, how much of an impact do ratings have on borrowing costs for sovereigns?

The collapse of AAA-rated structured finance products in 2007 to 2008 has brought renewed attention to conflicts of interest in credit rating agencies (CRAs). We model competition among CRAs with three sources of conflicts: (1) CRAs conflict of understating risk to attract business, (2) issuers' ability to purchase only the most favorable ratings, and (3) the trusting nature of some investor clienteles. These conflicts create two distortions. First, competition can reduce efficiency, as it facilitates ratings shopping. Second, ratings are more likely to be inflated during booms and when investors are more trusting. We also discuss efficiency-enhancing regulatory interventions.

This paper analyzes the response of stock and credit default swap (CDS) markets to rating announcements made by the three major rating agencies during the period 2000–2002. Applying event study methodology, we examine whether and how strongly these markets respond to rating ...

We document the determinants of the term to maturity of 7,369 bonds and notes issued between 1982 and 1993. Our main finding is that large firms with investment grade credit ratings typically borrow at the short end and at the long end and of the maturity spectrum, while firms with speculative grade credit ratings typically borrow in the middle of the maturity spectrum. This pattern is consistent with the theory that risky firms do not issue short-term debt in order to avoid inefficient liquidation, but are screened out of the long-term debt market because of the prospect of risky asset substitution.

Creditors often share information about their customers' credit record. Besides helping them to spot bad risks, this informational exchange acts as a disciplinary device. If creditors are known to exchange data about defaults, borrowers must consider that default on a current lender would disrupt their credit rating with all the other lenders. This raises their incentive to perform. But sharing more detailed information can reduce this disciplinary effect: when lenders only disclose past defaults, borrowers' incentives to perform may be greater than when lenders share all their information. In some instances, by "fine-tuning" the type and accuracy of the information shared, lenders can raise borrowers' incentives to their first-best level.

This paper establishes a robust link between momentum and credit rating. Momentum profitability is large and significant among low-grade firms, but it is nonexistent among high-grade firms. The momentum payoffs documented in the literature are generated by low-grade firms that account for less than 4% of the overall market capitalization of rated firms. The momentum payoff differential across credit rating groups is unexplained by firm size, firm age, analyst forecast dispersion, leverage, return volatility, and cash f low volatility.

We report the average costs of raising external debt and equity capital for U.S. corporations from 1990 to 1994. For initial public offerings (IPOs) of equity, the direct costs average 11.0 percent of the proceeds. For seasoned equity offerings (SEOs), the direct costs average 7.1 percent. For convertible bonds, the direct costs average 3.8 percent. For straight debt issues, the direct costs average 2.2 percent, although they are strongly related to the credit rating of the issue. All classes of securities exhibit economies of scale, although they are less pronounced for straight debt issues. IPOs also incur a substantial indirect cost due to short-run underpricing. Most large equity offers include an international tranche, although debt issues do not.

Credit Rating Agencies (CRAs) report information about the credit risk of fixed income securities. The various ways the information is used by financial, legal and regulatory entities may potentially influence the nature of the information production process. Bond ratings are not only used to assess risk, they are also used for regulatory certification, e.g. to classify securities into investment grade (IG) and high yield (HY, or junk) status. These classifications in turn influence institutional demand and serve as bright-line triggers in corporate credit arrangements and regulatory oversight. Regulations may mandate insurance companies and banks to keep much higher reserve capital for high yield issues than for investment grade corporate bonds. Other institutions like pension funds and mutual funds are often restricted by their charters in the amount of HY debt they can hold. Taken together, more than half of all corporate bonds are held by institutions that are subject to rating-based restrictions on their holdings of risky credit assets (Campbell and Taksler (2003)). Lower demand for high yield bond can significantly increase the cost of borrowing for those issuers and is related to capital structure decisions (see Ellul, Jotikasthira and Lundblad (2009), Kisgen and Strahan (2009), Kisgen (2006, 2009)). The institutional and regulatory importance of credit ratings to issuers and investors has raised questions about whether the current system provides the proper incentives for issuers to fully disclose value-relevant information, and for investors to invest in research about credit risk. Using a sample from 2000-2008, we document that almost all large, liquid US corporate bond issues are rated by both S&P and Moody's. Fitch typically plays the role of a "third opinion" for large bond issues 1. During the time period the most prevalent institutional rule used for classifying rated bonds was that, if an issue has two ratings, only the lower rating could be used to classify the issue (e.g. into investment-grade or non-investment grade). However, for issues with three ratings, the middle rating should be used (see, for example, the NAIC guidelines or the Basel II accord). 2 Therefore, if S&P and Moody's ratings are on opposite sides of the investment grade boundary, the Fitch rating (assuming it is the marginal, third rating) is the 'tie-breaker' and will decide into which class the issue falls. Moreover, this rule directly implies that adding a third rating cannot worsen the regulatory rating classification, but could potentially lead to a higher one. Consistent with this option, we find that in about 25% of Fitch rating additions, the addition leads to a regulatory rating improvement, i.e., the resulting middle rating is higher than the lowest rating before the Fitch rating addition. Ex ante, such an improvement would be particularly important when S&P and Moody's ratings are on opposite sides of the investment grade boundary. Absent the improving third rating, the split between S&P and Moody's would result in a classification of high yield. Thus, the value of the Fitch rating is that

This study investigates the aggregate stock market impact of sovereign rating changes. Consistent with evidence pertaining to company credit rating changes, we report that rating downgrades have a negative wealth impact on market returns. Moreover, we find that a downgrade impacts negatively on both the domestic stock market and the dollar value of the coun-tryÕs currency. Interestingly, of the four credit rating agencies examined, only Standard & Poors and Fitch rating downgrades result in significant market falls. Finally, we can find no evidence that emerging markets are particularly sensitive to rating changes or that markets react more severely to multiple rating changes.

The 1990s have witnessed pronounced boom-bust cycles in emergingmarkets lending, culminating in the Asian financial and currency crisis of 1997-8. By examining the links between sovereign credit ratings and dollar bond yield spreads over 1989-97, this paper aims at broad empirical content for judging whether the three leading rating agencies -Moody's, Standard & Poor's and Fitch IBCA -can intensify or attenuate boom-bust cycles in emerging-market lending. First, an event study exploring the market response for 30 trading days before and after rating announcements finds a significant impact of imminent upgrades and implemented downgrades for a combination of ratings by the three leading agencies, despite strong anticipation of rating events. Second, a Granger causality test, by correcting for joint determinants of ratings and yield spreads, finds that changes in sovereign ratings are mutually interdependent with changes in bond yields. These findings are based on many more observations than just the highly publicized crisis episodes in Mexico and Asia. They imply that sovereign ratings have the potential to moderate euphoria among investors on emerging-market bonds, but that the rating agencies have failed to exploit that potential over the past decade.

We study the determinants of sovereign debt credit ratings using rating notations from the three main international rating agencies, for the period 1995-2005. Using linear methods and ordered response models we employ a new specification that allows us to distinguish between short and long-run effects, on a country's rating, of several macroeconomic and fiscal explanatory variables. The results point to a good performance of the estimated models, across agencies and time, as well as a good overall prediction power. Changes in GDP per capita, GDP growth, government debt, government balance have a short-run impact on a country's credit rating, while government effectiveness, external debt, foreign reserves and default history are important long-run determinants. JEL: C23; C25; E44; F30; G15

We propose a dynamically consistent framework that allows joint valuation and estimation of stock options and credit default swaps written on the same reference company. We model default as controlled by a Cox process with a stochastic arrival rate. When default occurs, the stock price drops to zero. Prior to default, the stock price follows a jump-diffusion process with stochastic volatility. The instantaneous default rate and variance rate follow a bivariate continuous process, with its joint dynamics specified to capture the observed behavior of stock option prices and credit default swap spreads. Under this joint specification, we propose a tractable valuation methodology for stock options and credit default swaps. We estimate the joint risk dynamics using data from both markets for eight companies that span five sectors and six major credit rating classes from B to AAA. The estimation highlights the interaction between market risk (return variance) and credit risk (default arrival) in pricing stock options and credit default swaps.

two anonymous referees, and Stanley Pliska (the editor) for helpful comments and suggestions. They also thank David Lando for his communications with Jason Wei on the topic. Jeffrey Rosenthal acknowledges financial support by NSERC, and Jason Wei acknowledges financial support by SSHRC and the Connaught Fund of the University of Toronto.

The June 1999 and January 2001 proposals by the Ban for International Settlem ents (BIS) Basel Committee on Ban ing Supervision to include borrowers' credit ratings in a ssessments of the adequacy of ban s' capital have heightened general interest in the credit rating industry: Who the industry's firms are; what they do; how they do it; and what the consequences of their actions are. This paper uses the structure-behavior-performance paradigm of "industrial organ ization" to shed light on the credit rating industry and to provide a framewor for arranging ini tial observations and developing questions for further analysis.

Default probabilities are important to the credit markets. Changes in default probabilities may forecast credit rating migrations to other rating levels or to default. Such rating changes can affect the firm's cost of capital, credit spreads, bond returns, and the prices and hedge ratios of credit derivatives. While rating agencies such as Moodys and Standard & Poors compute historical default frequencies, option models can also be used to calculate forward looking or expected default frequencies. In this paper, we compute risk neutral probabilities or default (RNPD) using the diffusion models of Merton (1974) and Geske (1977). It is shown that the Geske model produces a term structure of RNPD's, and the shape of this term structure may forecast impending credit events. Next, it is shown that these RNPD's serve as bounds to estimates of actual default probabilities. Furthermore, the RNPD's exhibit the same comparative statics as the estimates of actual default probabilities. Also, the risk neutral default probabilities may be more accurately estimated than actual default probabilities because they do not require an estimate of the firm's drift. Given these similarities and advantages of RNPD's, their estimates may possess significant information about credit events. To confirm this an event study of the relation between RNPD and rating migrations is conducted. We first show that these RNPD's from both the Merton and Geske models do possess significant and very early information about credit rating migrations. While the sample of firms that actually default during this time period is small, changes in the shape of the term structure of default probabilities appears to detect impending migrations to default. This is shown to be consistent with an inverted term structure of default probabilities, where prior to an impending default, the short term default probability is higher than the forward default probability. Finally, since rating migrations to either lower ratings or to default can be detected months in advance these credit events may not be a surprise. 1 J.P. Morgan recently introduced Risk Metrics which deals with market risk and Credit Metrics which deals with credit risk. See www.jpmorgan.com for information about Risk Metrics and Credit Metrics. 2 Blyth Masters of J.P.Morgan estimates the credit derivatives market to exceed $500 billion dollars in notional. See her presentation at the Berkeley Program in Finance, (San Diego, September, 1997). 3 In this study of approximately ten years (1986-1996) of US corporations rated by Standard and Poors on Compustat, the number of rating migrations (1650) was much greater than the number of migrations to default (13) after screening for sufficient CRSP and Compustat data..

We explore for individual banks, active in the East Asian countries during the years 1996-1998, the performance of three sets of indicators of bank fragility that can be computed from publicly available information: accounting data, stock market prices, and credit ratings. We find significantly different patterns among the three groups of indicators in their ability of forecasting financial distress at a specific point in time and over time. More specifically, in the East Asia crisis episode the information based on stock prices or on judgmental assessments of credit rating agencies did not outpace backward looking information contained in balance sheet data. Stock market based information, though, has responded more quickly to changing financial conditions than ratings of credit risk agencies. Overall, the evidence supports the policy conclusion that, where the information processing is quite costly, as in most developing countries, it is important to use simultaneously a plurality of indicators to assess bank fragility.

Research and development (R&D) activities of firms can be seen as investments in the creation of knowledge. This basic fact makes raising funds for investment in R&D projects different from capital investment. R&D investment is not only characterized by high, sunk, firm-specific investment cost and low collateral value, but also by significant adjustment cost.

Low credit risk firms realize higher returns than high credit risk firms. This is puzzling because investors seem to pay a premium for bearing credit risk. The credit risk effect manifests itself due to the poor performance of low-rated stocks (which account for 4.2% of total market capitalization) during periods of financial distress. Around rating downgrades, low-rated firms experience considerable negative returns amid strong institutional selling, whereas returns do not differ across credit risk groups in stable or improving credit conditions. The evidence for the credit risk effect points towards mispricing generated by retail investors and sustained by illiquidity and short sell constraints.

Modern corporate finance theory argues that although bank monitoring is beneficial to borrowers, it also allows banks banks to use the private information they gain through monitoring to "hold-up" borrowers for higher interest rates. In this paper, we seek empirical evidence for this information hold-up cost. Since new information about a firm's creditworthiness is revealed at the time of its first issue in the public bond market, it follows that after firms undertake their bond IPO, banks with an exploitable information advantage will be forced to adjust their loan interest rates downwards, particularly for firms that are revealed to be safe. Our findings show that firms are able to borrow from banks at lower interest rates after they issue for the first time in the public bond market and that the magnitude of these savings is larger for safer firms. We further find that among safe firms, those that get their first credit rating at the time of their bond IPO benefit from larger interest rate savings than those that already had a credit rating when they entered the bond market. Since more information is revealed at the time of the bond IPO on the former firms and since this information will increase competition from uninformed banks, these findings provide support for the hypothesis that banks price their informational monopoly. Finally, we find that while entering the public bond market may reduce these informational rents, it is costly to firms because they have to pay higher underwriting costs on their IPO bonds. Moreover, IPO bonds are subject to more underpricing than subsequent bonds when they first trade in the secondary bond market.

Credit migration matrices are cardinal inputs to many risk management applications; their accurate estimation is therefore critical. We explore two approaches: cohort and two variants of duration-one imposing, the other relaxing time homogeneity-and the resulting differences, both statistically through matrix norms and economically using a credit portfolio model. We propose a new metric for comparing these matrices based on singular values and apply it to credit rating histories of S&P rated US firms from 1981-2002. We show that the migration matrices have been increasing in ''size'' since the mid-1990s, with 2002 being the ''largest'' in the sense of being the most dynamic. We develop a testing procedure using bootstrap techniques to assess statistically the differences between migration matrices as represented by our metric. We demonstrate that it can matter substantially which estimation method is chosen: economic credit risk capital differences implied by different estimation techniques can be as large as differences between economic regimes, recession vs. expansion. Ignoring the efficiency gain inherent in the duration methods by using the cohort method instead is more damaging than imposing a (possibly false) assumption of time homogeneity.

Rating transition matrices for sovereigns are an important input to risk management of portfolios of emerging market credit exposures. They are widely used both in credit portfolio management and to calculate future loss distributions for pricing purposes.

The recent consultative papers by the Basel Committee suggest an explicit role for external rating agencies in the assessment of the credit risk of banks' assets. In this context, an assessment of the information contained in credit ratings is important. We address this issue via an event study of rating change announcements by leading international rating agencies, focussing on a sample of European banks. We find no evidence of announcement effects on bond prices. We are largely able to exclude lack of liquidity as an explanation for this puzzling result and suggest some alternatives, such as "too-big-to-fail." For equity prices, we find strong effects of unexpected ratings changes and confirm prior evidence that stock prices may react very differently to ratings downgrades, depending on the underlying reason. Overall, our results suggest that ratings agencies may perform a useful role in summarising and obtaining non-public information on banks, at least for stockholders.

The effect of credit market competition on borrower default is theoretically ambiguous, because the quantity of credit supplied may rise or fall following an increase in competition. We investigate empirically the relationship between credit market competition, lending to households, and personal bankruptcy rates in the United States. We exploit the exogenous variation in market contestability brought on by banking deregulation at the state level: after deregulation, banks faced the threat of entry into their state markets. We find that deregulation increased competition for borrowers, prompting banks to adopt more sophisticated credit rating technology. In turn, these developments led previously excluded households to enter the credit market. We document that, following deregulation, (1) overall lending increased, (2) loss rates on loans decreased, and (3) bankruptcy rates rose. Further, we find that lending and bankruptcy rates increased more in states with greater actual (rather than potential) entry, and that credit card productivity increased after the removal of entry restrictions. These findings suggest that entrants brought with them enhanced underwriting technology that allowed for credit extension to new borrowers.

Employees of liquidating firms are likely to lose income and non-pecuniary benefits of working for the firm, which makes bankruptcy costly for employees. This paper examines whether firms take these costs into account when deciding on the optimal amount of leverage. We find that firms with leading track records in employee well-being significantly reduce the probability of bankruptcy by operating with lower debt ratios. Moreover, we observe that firms with better employee track records have better credit ratings, even when we control for differences in firm leverage. Ó 2009 Elsevier B.V. All rights reserved. ''To succeed a corporation requires a co-investment of financial capital from the outside and human capital that is built up inside the business. You need the human capital to make the business work in the long run. [.. .] When you ask people to make an investment of human capital in your firm, you do not then do things-like raising the leverage ratio too highthat would needlessly put that investment at risk.'' Stewart Myers (Myers et al., 1998)

How does the sovereign credit ratings history provided by independent ratings agencies affect domestic financial sector development and international capital inflows to emerging countries? We address this question utilizing a comprehensive dataset of sovereign credit ratings from Standard and Poor's from 1995-2003 for a cross-section of 51 emerging markets. Within a panel data estimation framework, we examine financial sector development and the influence of sovereign credit ratings provision, controlling for various economic and corporate governance factors identified in the financial development literature. We find strong evidence that our sovereign credit rating measures do affect financial intermediary sector developments and capital flows. We find that i) long-term foreign currency sovereign credit ratings are important for encouraging financial intermediary development and for attracting capital flows. ii) Long-term local currency ratings stimulate domestic market growth but discourage international capital flows. iii) Short-term ratings (both foreign and local currency denominated) retard all forms of financial developments and capital flows. There are important implications in this research for policy makers to encourage the provision of longerterm credit ratings to promote financial development in emerging economies.

The evidence here indicates that sovereign debt rating and credit outlook changes of one country have an asymmetric and economically significant effect on the stock market returns of other countries over 1989-2003. There is a negative reaction of 51 basis points (two-day return spread vis-á-vis the US) to a credit ratings downgrade of one notch in a common information spillover around the world. Upgrades, however, have no significant impact on return spreads of countries abroad. Closeness (e.g., geographic proximity) and emerging market status amplify the effect of a spillover. Downgrade spillover effects at the industry level are more pronounced in traded goods and small industries.

Despite mounting evidence to the contrary, credit migration matrices, used in many credit risk and pricing applications, are typically assumed to be generated by a simple Markov process. Based on empirical evidence, we propose a parsimonious model that is a mixture of (two) Markov chains, where the mixing is on the speed of movement among credit ratings. We estimate this

This paper examines the role of credit rating agencies in the subprime crisis that triggered the 2007-08 financial turmoil. We focus on two aspects of ratings that contributed to the boom and bust of the market for structured debt: rating inflation and coarse information disclosure. The paper discusses how regulation can be designed to mitigate these problems in the future. Our preferred policy is to require rating agencies to be paid by investors rather than by issuers and to grant open and free access to data about the loans or securities underlying structured debt products. A more modest (but less effective) approach would be to retain the "issuer pays" model but require issuers to pay an upfront fee irrespective of the rating, ban "rating shopping", and prescribe a more complete format for the information that rating agencies must disseminate. JEL Classification: D82, G18, G21

We investigate agency variation in credit quality assessment (Standard and Poor's vs. Moody's vs. Fitch) employing sovereign ratings data for 129 countries, spanning the period 1990-2006. While we find that the credit rating agencies often disagree about credit quality, it is usually confined to one or two notches on the finer scale. We find that several variables have varying importance in explaining ratings across agencies which leads us to conclude that material heterogeneity exists between them. Also, while watch and outlook procedures are generally strong predictors of rating changes relative to other public data, additional significant variables suggest that it might be possible to augment these agency data to provide better forecasts of future rating changes.

I conduct an analysis of the possible determinants of sovereign credit ratings assigned by the two leading credit rating agencies, Moody's and Standard and Poor's, by using both a linear and a logistic transformation of the rating scales. Of the large number of variables that can be used, the set of explanatory variables selected in this study is significant in explaining the credit ratings. Namely, six variables appear to be the most relevant to determine a country's credit rating: GDP per capita, external debt, level of economic development, default history, real growth rate and inflation rate.

This paper critically reviews the debate on CRAs and, in the light thereof, analyses the European regulatory approach to CRAs, thereby combining insights from economics and law. We first provide some basic background on the function of CRAs. Thereafter, we focus on the two main tasks for which CRAs have come under criticism, namely the issuing of sovereign ratings and the rating of structured instruments. Finally, we zoom in on the question of whether and how CRAs should be regulated given their function, focusing on recent European legislation that aims to standardize the conduct of CRAs.

This article analyzes how external crises spread across countries. The authors analyze the behavior of four alternative crisis indicators in a sample of 20 countries during three well-known crises: the 1982 debt crisis, the 1994 Mexican crisis, and the 1997 Asian crisis. The objective is twofold: to revisit the transmission channels of crises, and to analyze whether capital controls, exchange rate flexibility, and debt maturity structure affect the extent of contagion. The results indicate that there is a strong neighborhood effect. Trade links and similarity in precrisis growth also explain (to a lesser extent) which countries suffer more contagion. Both debt composition and exchange rate flexibility to some extent limit contagion, whereas capital controls do not appear to curb it.

This paper assesses biases in credit ratings and lead-lag relationships for near-to-default issuers with multiple ratings by Moody's and S&P. Based on defaults from 1997 to 2004, we find evidence that Moody's seems to adjust its ratings to increasing default risk in a timelier manner than S&P. Second, credit ratings by the two US-based agencies are not subject to any home preference. Third, given a downgrade (upgrade) by the first rating agency, subsequent downgrades (upgrades) by the second rating agency are of greater magnitude in the short term. Fourth, harsher rating changes by one agency are followed by harsher rating changes in the same direction by the second agency. Fifth, rating changes by the second rating agency are significantly more likely after downgrades than after upgrades by the first rating agency. Additionally, we find evidence for serial correlation in rating changes up to 90 days subsequent to the rating change of interest after controlling for rating changes by the second rating agency.