The Effect of Changes in Credit Ratings on Equity Returns

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The Effect of Changes in Credit Ratings on Equity Returns

Postby Anup V » Tue Aug 07, 2012 11:10 pm

The link between credit risk and return patterns on equity markets has increasingly become an area of interest. In this thesis we investigate the existence of a systematic relationship between credit ratings, as indicators of credit risks, and abnormal equity returns. In particular, we investigate the announcement effect on equity returns associated with credit rating changes. Furthermore, we contribute to the understanding of the observed announcement effects by relating them to various components of the rating process. We base our study on a sample of credit rating changes from March 1990 to February 2006 by Moody’s and Standard and Poor’s for companies listed in the Nordic countries. We find that downgrade announcements on average are associated with negative abnormal share price reactions, whereas no systematic reaction is associated with upgrades. Through sub sample and cross-sectional analyses we gain a deeper understanding of the driving forces behind the characteristics of the observed announcement effects.

In general, we argue that variations in announcement effects are driven by various event and issuer specific characteristics and that these can be related to the relevance and implication of the information as well as the degree of market anticipation. Specifically, rating updates driven by changes in profitability and market position are more pricing relevant than those motivated by changes in capital structure. Also, rating events preceded by official opinions of the likely direction of the rating update have less pricing impact. Based on these two dimensions we identify several additional aspects of the credit rating process with implications for the impact on equity returns. These explanatory factors provide the foundation for a comprehensive analysis of the asymmetric reactions between upgrades and downgrades as well as for the cross-sectional variations for both rating events.

The aim of this thesis is to provide further insights to the link between credit risks and the corresponding impact on equity returns. In particular, our aim is to study the impact of credit rating changes on abnormal equity returns around the time of the announcement. For the purpose of identifying the factors of relevance for potential links between indicators of credit risks and return patterns on equity markets, various aspects of the credit rating process are analysed and interpreted with focus on the impact on equity investors.

Based on this approach, the purpose of the thesis isi) to investigate whether there is a systematic and robust link between indicators of credit risk and return patterns on equity markets as well as ii) to explain the dynamics of a potential relationship based on observable characteristics.

Hence, the purpose can be summarized by two research questions:

Is there a systematic link between credit ratings, as indicators of credit risk, and the return patterns on equity markets?

How can variations in issuer and event specific characteristics explain potential announcement effects on equity returns associated with credit rating changes?

The link between credit risk and bond returns is very intuitive, whereas the effect on equity returns is less clear. Several related studies have studied the existence of announcement effects on equity returns associated with credit rating transitions. The results, which are primarily based on US data, are rather inconclusive. Nevertheless, a majority of previous studies have concluded that the announcement reaction associated with downgrades is considerably larger than that found for upgrades. Appendix B provides a more comprehensive overview of related previous research.

Objective of the Project

Our main approach to test the abnormal share price reaction associated with credit rating changes is to perform an event study over relevant event windows and test for significance using regular parametric tests. For the purpose of estimating the parameters for the calculation of normal returns we have selected an estimation window involving 180 trading days from t = +60 to t = +240 , where the day of the rating announcement, the event day, is denoted t = 0 . The choice of a post-event estimation period is based on the general finding that the period prior to the announcement generally is associated with a downward (upward) share price drift for downgrades (upgrades).

To study the timing of potential share price reactions we have defined several event windows. The event window used to study the announcement effect is defined from t = 0 to t = +1. The following trading day is included since the announcement of an updated credit rating may not affect the closing price until the following day if the trading on the event day had stopped at the time of the announcement. In order to test whether the choice of event window affects the results we also used an alternative definition of the event window including the announcement only (t = 0).

Thesis By : Thomas Bergha & Olof Lennströmb, Stockholm School of Economics

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