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Published on Sep 03, 2023


With debt markets continuously growing, bond ratings have been built into financial arrangements of all kinds. Today, bond ratings are the principal source of investor information about the “quality” and marketability of issued debt. Several mutual funds and pension funds have even restricted their investment to bonds of above a certain rating, and to invest in debt without a rating is, for many investors, seen as unthinkable.

The inclusion of bond ratings as an important input in the new Basel II capital requirements for banks has increased the importance of bond ratings even further. A more direct consequence for the company is the fact that the cost of a company’s debt often is tied to the current rating of its debt. A change in a credit rating can therefore have a direct impact on a firm’s costs. The officially accepted ratings agencies consist of a few players with two agencies being much larger than the others, Moody’s and Standard & Poor’s (S&P). Moody’s alone currently rates the issuers of more than 90% of the long term debt issued in cross-border markets by European issuers and worldwide they have assigned ratings to over 10,000 company issuers and 25,000 public finance issuers.

The two companies are also profitable with high revenue growth and profit margins around 50% (The Economist). The power of the rating agencies has raised several questions about their roles in the market as well as their methods. One returning question is regarding the potential conflict of interest due to the fact that the raters are not paid by the investors but rather by the bond issuers themselves. Another question is the fact that the rating agencies recently have started consulting arms specializing in helping companies receive a better bond rating, issued by the same agencies who supply the consulting services.

The main research on the topic of credit ratings in connection with stock prices has been focused on the degree of ratings inherent informative content for equity investors. There are also a number of studies that have empirically tested the suggested relationship between bond/credit ratings and stock prices. However, the majority of previous studies have only tried to determine if such a relationship can be observed on the whole. As will be described in section 2, varying results have been found even though a general conclusion is that rating changes have some degree of impact on the stock markets, especially downgrades. The research field has developed into more refined and specific hypotheses surrounding credit ratings and their relationship to stock prices. For many reasons, the American market is the one single market most extensively investigated. While a few studies have been performed on companies in various countries in Europe, no study has tried to examine a sample that would be representative of all of Europe as a common/single corporate cohort. One reason for this could be that Europe is not a homogenous market as opposed to the American counterpart. Instead, the total European market consists of several different exchanges, national currencies, and accounting principles.

Objective of the Project

The purpose of this thesis is to empirically test the credit rating changes’ impact on the stock market. We hope to contribute to previous research on the subject by specifically performing an all European survey and to further empirically test the results found by Goh and Ederington that only certain categories of rating changes carries significant new information for the stock market. Moreover we will complement the research field with a study which comprehensively and exclusively examines the 21th century’s prevailing situation.

The Efficient Market Hypothesis

According to the EMH, the stock market is a highly effective pricing mechanism. The hypothesis asserts that all relevant information related to a particular stock and/or market is incorporated in the market price of the security. The efficient market hypothesis was originally formulated by Eugene Fama in 1970. The efficient market hypothesis implies that it is impossible to outperform the market based on information that is already available to the public. The hypothesis further suggests that the future flow of news, which consequently will determine the future prices, is random and hence impossible to predict in the present. EMH assumes that new information is incorporated quickly and correctly into the market price. EMH however, does not require that investors behave rationally.

When faced with new information, some investors may overreact and some may underreact. EMH only requires that investors’ reactions are random enough that the net effect on the market cannot be exploited to make an abnormal profit. There exist three major efficiency categories based on EMH; the weak form efficiency, semi-strong form efficiency and strong form efficiency. Each form’s assumptions have different implications for how a market works.

Weak form efficiency – The weak form states that stock prices reflect all historical security prices and other data such as trading volume. Weak form implies that no Technical Analysis models can be used to obtain abnormal returns.

Semi-Strong efficiency – The semi-strong efficiency suggests that all publicly available information is reflected in the stock price and that they adjust instantaneously to new such information. Semi-strong efficiency implies that Fundamental Analysis models will not be able to readily produce excess returns.

Strong market efficiency – This form assumes that stock prices include all information, even insider information, and that it is consequently impossible for anyone or to earn abnormal returns.

The assumption that markets are efficient in the semi-strong form is most commonly claimed to be correct and it is also the form we will test in our thesis. This would consequently suggest that if credit ratings contain new information, the stock price should be adjusted instantaneously. In light of EMH we further assume that information about a credit rating change is immediately available to all marginal investors and that the underlying reason for the rating revision is instantaneously assessed by the market.

Thesis By : Mattias Karlberg (18826) & Gustav Wetterling (19239), Stockholm School of Economics

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