Cross-Sectional Variation in Stock Price Reaction to Bond Rating Changes: Evidence from India (Introduction-1)

Cross-Sectional Variation in Stock Price Reaction to Bond Rating Changes: Evidence from India (Introduction-1)Credit rating agencies play a very vital role in the financial markets by providing an opinion about the ‘quality’ or ‘creditworthiness’ of a particular debt instrument to the investors. The ratings define the default risk for the bond issue over its life. While the investors gain from this assessment, it is claimed that the firms also benefit because ratings and subsequent rating changes are an effective means of conveying confidential inside information to the investors without revealing anything to the competitors. However, recently the rating agencies have been severely criticized. The lack of prompt response by the rating agencies during the East Asian Financial Crisis (1997), the failures of Enron (2001), Worldcom (2002) and Subprime Mortgage crisis (2008) have put a question mark on their reliability and credibility.
The issue regarding the informational content of the ratings has been debated. One school of thought believes that ratings only lower the borrowing costs but do not tell anything new (Wakeman, 1990). The agency’s rating change action is based on publicly available information and lags the event. Thus, the announcement of bond rating changes would not affect market prices, assuming the capital markets are efficient in semi-strong form. Many studies support the premise that bond rating changes do not provide new information.
On the other hand, the credit rating agencies claim to possess superior information about the company which is used by them for arriving at their ratings. Therefore, any change in the ratings would affect security prices.
Again, the exact nature of relationship between rating changes and stock returns needs to be understood. There are two main theories which explain the impact of rating change announcements by the credit rating agency on stock prices. These are -Information Asymmetry and Signalling Hypothesis and Wealth Redistribution Hypothesis. The signalling hypothesis suggests that a rating change provides additional information to the market about total value of the firm. A rating change may be seen as a signal indicating future earnings and cash flows of the issuer.

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