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Rating model arbitrage in CDO markets: An empirical analysis

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Author Info

  • Morkötter, Stefan
  • Westerfeld, Simone

Abstract

We analyze whether information asymmetry between issuers and investors leads to rating model arbitrage in Collateralized Debt Obligation markets. Rating model arbitrage is defined as the issuer's deliberate capitalization of information asymmetry at the investor's cost on the basis of different rating processes. Using data from CDO transactions grouped by both rating agencies and underlying rating methodologies, we test for homogeneity of characteristic transaction features within the group and heterogeneity between the different groups. We find that the hypothesis stating non-existence of rating model arbitrage on the basis of information asymmetry does not hold as individual patterns of transaction characteristics within each group could be identified.

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Bibliographic Info

Article provided by Elsevier in its journal International Review of Financial Analysis.

Volume (Year): 18 (2009)
Issue (Month): 1-2 (March)
Pages: 21-33

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Handle: RePEc:eee:finana:v:18:y:2009:i:1-2:p:21-33

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Web page: http://www.elsevier.com/locate/inca/620166

Related research

Keywords: Rating model arbitrage Collateralized Debt Obligations Asymmetric information;

References

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  1. Flannery, Mark J, 1986. " Asymmetric Information and Risky Debt Maturity Choice," Journal of Finance, American Finance Association, vol. 41(1), pages 19-37, March.
  2. Fazzari, Steven M & Athey, Michael J, 1987. "Asymmetric Information, Financing Constraints, and Investment," The Review of Economics and Statistics, MIT Press, vol. 69(3), pages 481-87, August.
  3. Li L. Ong & Jorge A. Chan-Lau, 2006. "The Credit Risk Transfer Market and Stability Implications for U.K. Financial Institutions," IMF Working Papers 06/139, International Monetary Fund.
  4. Cantor, Richard & Packer, Frank, 1997. "Differences of opinion and selection bias in the credit rating industry," Journal of Banking & Finance, Elsevier, vol. 21(10), pages 1395-1417, October.
  5. Hayne E. Leland and David H. Pyle., 1976. "Informational Asymmetries, Financial Structure, and Financial Intermediation," Research Program in Finance Working Papers 41, University of California at Berkeley.
  6. Norden, Lars & Weber, Martin, 2004. "Informational Efficiency of Credit Default Swap and Stock Markets: The Impact of Credit Rating Announcements," CEPR Discussion Papers 4250, C.E.P.R. Discussion Papers.
  7. Ingo Fender & John Kiff, 2004. "CDO rating methodology: Some thoughts on model risk and its implications," BIS Working Papers 163, Bank for International Settlements.
  8. Goswami, Gautam & Noe, Thomas H & Rebello, Michael J, 1995. " Debt Financing under Asymmetric Information," Journal of Finance, American Finance Association, vol. 50(2), pages 633-59, June.
  9. Fama, Eugene F, 1980. "Agency Problems and the Theory of the Firm," Journal of Political Economy, University of Chicago Press, vol. 88(2), pages 288-307, April.
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Citations

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Cited by:
  1. Duan, Jin-Chuan & Van Laere, Elisabeth, 2012. "A public good approach to credit ratings – From concept to reality," Journal of Banking & Finance, Elsevier, vol. 36(12), pages 3239-3247.
  2. Lawrence J. White, 2010. "Markets: The Credit Rating Agencies," Journal of Economic Perspectives, American Economic Association, vol. 24(2), pages 211-26, Spring.
  3. Lawrence J. White, 2013. "Credit Rating Agencies: An Overview," Working Papers 13-10, New York University, Leonard N. Stern School of Business, Department of Economics.

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