Cross-Sectional Variation in Stock Price Reaction to Bond Rating Changes: Evidence from India (Introduction-4)

A related issue is whether the investors react more strongly where the change in bond rating is from investment to speculative grade in case of downgrades. Holthausen and Leftwich (1986); Hite and Warga (1997); Creighton, Gower and Richards (2007); Benjamin (2008) and Lal and Mitra (2011) found that downgrades resulting in change in category of bond from investment to speculative grade extract a larger price response than any other downgrades. Similarly, it is expected that where the bond ratings are in the speculative grade the shareholders may respond more intensely due to higher risk of default of such bonds. Another factor under consideration is the influence of bad economic conditions on the post – event abnormal returns in case of rating changes. The time frame in this study includes the period when the investor sentiments were negative due to the sub-prime mortgage crisis. In such times, the investors expect bad news like the announcement of downgrades. They also under react to positive news like announcement of upgrades though there is an element of surprise. Moreover, the degree of risk aversion increases in recession, so the price reactions are expected to be stronger. This paper also considers the influence of all such factors on the price response of firm – characteristic based portfolios (size, P/B, trading volume, leverage, intangibility and profitability) to bond rating changes.
A review of the past research shows that although a lot of studies on the changes in ratings and their relationship with stock returns have been conducted abroad; there is little research on the subject in India. The limited literature which exists concentrates more on the comparison and analysis of rating methodologies and the performance of various rating agencies.

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