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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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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. Spatt, Chester & Srivastava, Sanjay, 1991. "Preplay Communication, Participation Restrictions, and Efficiency in Initial Public Offerings," Review of Financial Studies, Society for Financial Studies, vol. 4(4), pages 709-26.
  2. Douglas Gale, 1992. "Informational Capacity and Financial Collapse," Papers, Boston University - Industry Studies Programme 0038, Boston University - Industry Studies Programme.
  3. Mark Carey & Mark Hrycay, 2000. "Parameterizing credit risk models with rating data," Finance and Economics Discussion Series, Board of Governors of the Federal Reserve System (U.S.) 2000-47, Board of Governors of the Federal Reserve System (U.S.).
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  8. 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, American Finance Association, vol. 47(2), pages 733-52, June.
  9. Townsend, Robert M., 1979. "Optimal contracts and competitive markets with costly state verification," Journal of Economic Theory, Elsevier, vol. 21(2), pages 265-293, October.
  10. 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.
  11. 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.
  12. Diamond, Douglas W, 1984. "Financial Intermediation and Delegated Monitoring," Review of Economic Studies, Wiley Blackwell, Wiley Blackwell, vol. 51(3), pages 393-414, July.
  13. Stephen Morris, 1999. "Political Correctness," Cowles Foundation Discussion Papers, Cowles Foundation for Research in Economics, Yale University 1242, Cowles Foundation for Research in Economics, Yale University.
  14. Alessandro Lizzeri, 1999. "Information Revelation and Certification Intermediaries," RAND Journal of Economics, The RAND Corporation, vol. 30(2), pages 214-231, Summer.
  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, University of Chicago Press, vol. 99(4), pages 689-721, August.
  16. 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.
  17. Harris, Milton & Raviv, Artur, 1998. "Capital budgeting and delegation," Journal of Financial Economics, Elsevier, Elsevier, vol. 50(3), pages 259-289, December.
  18. 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.
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