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Credit Ratings as Coordination Mechanisms

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  • Arnoud W.A. Boot

    ()
    (University of Amsterdam)

  • Todd T. Milbourn

    ()
    (Washington University in St Louis)

Abstract

In this article, we provide a novel rationale for credit ratings. The rationale that we propose is that credit ratings serve as a coordinating mechanism in situations where multiple equilibria can obtain. We show that credit ratings provide a "focal point" for firms and their investors, and explore the vital, but previously overlooked implicit contractual relationship between a credit rating agency (CRA) and a firm through its credit watch procedures. Credit ratings can help fix the desired equilibrium and as such play an economically meaningful role. Our model provides several empirical predictions and insights regarding the expected price impact of rating changes. This discussion paper has resulted in a publication in The Review of Financial Studies , 2006, 19(1), 81-118.

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Bibliographic Info

Paper provided by Tinbergen Institute in its series Tinbergen Institute Discussion Papers with number 02-058/2.

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Date of creation: 21 Jun 2002
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Handle: RePEc:dgr:uvatin:20020058

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Web page: http://www.tinbergen.nl

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  1. Milton Harris & Artur Raviv, 1997. "Capital Budgeting and Delegation," CRSP working papers 452, Center for Research in Security Prices, Graduate School of Business, University of Chicago.
  2. Gale, D., 1992. "Informational Capacity and Financal Collapse," Papers 38, Boston University - Industry Studies Programme.
  3. Hand, John R M & Holthausen, Robert W & Leftwich, Richard W, 1992. " The Effect of Bond Rating Agency Announcements on Bond and Stock Prices," Journal of Finance, American Finance Association, vol. 47(2), pages 733-52, June.
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  7. Pamela Nickell & William Perraudin & Simone Varotto, 2001. "Ratings versus equity-based credit risk modelling: an empirical analysis," Bank of England working papers 132, Bank of England.
  8. Stephen Morris, 2001. "Political Correctness," Journal of Political Economy, University of Chicago Press, vol. 109(2), pages 231-265, April.
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  12. Robert Townsend, 1979. "Optimal contracts and competitive markets with costly state verification," Staff Report 45, Federal Reserve Bank of Minneapolis.
  13. 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.
  14. Ederington, Louis H. & Goh, Jeremy C., 1998. "Bond Rating Agencies and Stock Analysts: Who Knows What When?," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 33(04), pages 569-585, December.
  15. Diamond, Douglas W, 1991. "Monitoring and Reputation: The Choice between Bank Loans and Directly Placed Debt," Journal of Political Economy, University of Chicago Press, vol. 99(4), pages 689-721, August.
  16. Louis H. Ederington & Jess B. Yawitz & Brian E. Roberts, 1984. "The Informational Content of Bond Ratings," NBER Working Papers 1323, National Bureau of Economic Research, Inc.
  17. Doron Kliger & Oded Sarig, 2000. "The Information Value of Bond Ratings," Journal of Finance, American Finance Association, vol. 55(6), pages 2879-2902, December.
  18. Diamond, Douglas W, 1984. "Financial Intermediation and Delegated Monitoring," Review of Economic Studies, Wiley Blackwell, vol. 51(3), pages 393-414, July.
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