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Asset pricing, asymmetric information and rating announcements: does benchmarking on ratings matter?

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  • Spyros Pagratis
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    Abstract

    Using an intertemporal model of asset pricing under asymmetric information, we demonstrate how public ratings about the quality of a risky asset could enhance information efficiency, albeit at a cost of higher asset price volatility. The analysis also draws implications for the use of ratings for benchmarking purposes, in particular, ratings-based capital requirements and an investment/subinvestment grade dichotomy depending on the rating of the asset. In this situation, allowing a class of market participants (eg pension funds) to hold an asset only if its rating exceeds a certain threshold may lead informed traders to overreact to news about fundamentals. In this case, ratings induce lower price efficiency and excessive asset price volatility.

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    File URL: http://www.bankofengland.co.uk/research/Documents/workingpapers/2005/WP265.pdf
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    Paper provided by Bank of England in its series Bank of England working papers with number 265.

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    Date of creation: Jun 2005
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    Handle: RePEc:boe:boeewp:265

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    1. Laura Veldkamp, 2003. "Media Frenzies in Markets for Financial Information," Working Papers 03-20, New York University, Leonard N. Stern School of Business, Department of Economics.
    2. Eric van Wincoop & Philippe Bacchetta, 2004. "Can Information Heterogeneity Explain the Exchange Rate Determination Puzzle?," Econometric Society 2004 North American Winter Meetings 628, Econometric Society.
    3. Marcia H. Millon & Anjan V. Thakor, 2004. "Moral Hazard and Information Sharing: A Model of Financial Information Gathering Agencies," Finance 0411024, EconWPA.
    4. Stephen Morris & Franklin Allen & Hyun Song Shin, 2004. "Beauty Contests, Bubbles and Iterated Expectations in Asset Markets," Yale School of Management Working Papers ysm346, Yale School of Management.
    5. Sanford J Grossman & Joseph E Stiglitz, 1997. "On the Impossibility of Informationally Efficient Markets," Levine's Working Paper Archive 1908, David K. Levine.
    6. Sargent, Thomas J., 1991. "Equilibrium with signal extraction from endogenous variables," Journal of Economic Dynamics and Control, Elsevier, vol. 15(2), pages 245-273, April.
    7. Foster, F Douglas & Viswanathan, S, 1996. " Strategic Trading When Agents Forecast the Forecasts of Others," Journal of Finance, American Finance Association, vol. 51(4), pages 1437-78, September.
    8. Foster, F Douglas & Viswanathan, S, 1993. "The Effect of Public Information and Competition on Trading Volume and Price Volatility," Review of Financial Studies, Society for Financial Studies, vol. 6(1), pages 23-56.
    9. Townsend, Robert M, 1983. "Forecasting the Forecasts of Others," Journal of Political Economy, University of Chicago Press, vol. 91(4), pages 546-88, August.
    10. Hussman, John P., 1992. "Market efficiency and inefficiency in rational expectations equilibria : Dynamic effects of heterogeneous information and noise," Journal of Economic Dynamics and Control, Elsevier, vol. 16(3-4), pages 655-680.
    11. Hellwig, Martin F., 1980. "On the aggregation of information in competitive markets," Journal of Economic Theory, Elsevier, vol. 22(3), pages 477-498, June.
    12. Kyle, Albert S, 1985. "Continuous Auctions and Insider Trading," Econometrica, Econometric Society, vol. 53(6), pages 1315-35, November.
    13. Diamond, Douglas W. & Verrecchia, Robert E., 1981. "Information aggregation in a noisy rational expectations economy," Journal of Financial Economics, Elsevier, vol. 9(3), pages 221-235, September.
    14. Diamond, Douglas W, 1985. " Optimal Release of Information by Firms," Journal of Finance, American Finance Association, vol. 40(4), pages 1071-94, September.
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