Cross-Sectional Variation in Stock Price Reaction to Bond Rating Changes: Evidence from India (Introduction-3)

Cross-Sectional Variation in Stock Price Reaction to Bond Rating Changes: Evidence from India (Introduction-3)Dichev and Piotroski (2001) and Creighton, Gower and Richards (2007) reported stronger price reaction for small firms. Avramov et al. (2009) ran cross-sectional regressions of monthly individual stock returns on credit rating and other firm characteristics including book value to market value ratio but did not find it to significantly affect the returns. Cornell, Landsman and Shapiro (1989) found that a firm’s stock price response to bond rating variations depends on the net intangible assets of the firm. Kliger and Sarig (2000) show that the bond price reaction to rating change was positively affected by the firm’s leverage. In contrast, Goh and Ederington (1993) report that downgrades arising due to a change in the leverage of the firm did not affect the prices of stocks significantly. The actual direction of the impact on returns depends on whether earnings or leverage or both are a surprise.
Apart from firm characteristics, there are a number of other factors which influence the response of share prices to a bond rating change. All other things remaining the same, the market should only show price response to a surprise or unanticipated rating change. This implies that the pre – event and post – event returns should be negatively correlated. Another factor which affects their relationship is the ‘importance’ of the information being conveyed by the rating change. Importance refers to the intrinsic value of the information as perceived by the investors. More vital the information being conveyed, the stronger is the price reaction both before and after rating change announcement implying a positive correlation between the pre – announcement and post – announcement returns.
Another variable shaping the response of share prices to the rating change announcements is the magnitude of rating change i.e. the number of grades or levels by which the rating is changed. Cornell, Landsman and Shapiro (1989) and Hand, Holthausen and Leftwich (1992) found that the number of rating grades changed on rating revision has a significant influence on returns.

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