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Contracting on Credit Ratings: Adding Value to Public Information

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  • Christine A Parlour
  • Uday Rajan

Abstract

We consider the role of credit ratings when contracts between investors and portfolio managers are incomplete. In our model, a credit rating and a price on a risky bond both provide verifiable signals about a non-contractible state. We allow the investor to both impose ex ante restrictions on the manager’s action and provide outcome-based compensation. The optimal contract is a prohibitive one when the rating and price indicate a high likelihood of a low state, and relies on wages when the low state is less likely. We provide some observable implications of our contracting approach to ratings.Received May 10, 2016; editorial decision April 17, 2019 by Editor Itay Goldstein.

Suggested Citation

  • Christine A Parlour & Uday Rajan, 2020. "Contracting on Credit Ratings: Adding Value to Public Information," The Review of Financial Studies, Society for Financial Studies, vol. 33(4), pages 1412-1444.
    • Handle: RePEc:oup:rfinst:v:33:y:2020:i:4:p:1412-1444.
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    File URL: http://hdl.handle.net/10.1093/rfs/hhz083
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    Cited by:

    1. Dong, Yi & Hou, Qiannan & Ni, Chenkai, 2021. "Implicit government guarantees and credit ratings," Journal of Corporate Finance, Elsevier, vol. 69(C).
    2. Anna Bayona & Oana Peia & Razvan Vlahu, 2023. "Credit Ratings and Investments," Working Papers 776, DNB.
    3. Singh, Amanjot & Singh, Harminder, 2022. "Insiders' stock pledging disclosures and credit ratings: Evidence from India," Pacific-Basin Finance Journal, Elsevier, vol. 75(C).
    4. Itay Goldstein & Chong Huang, 2020. "Credit Rating Inflation and Firms' Investments," Journal of Finance, American Finance Association, vol. 75(6), pages 2929-2972, December.
    5. Terovitis, Spyros, 2022. "Information disclosure and the feedback effect in capital markets," Journal of Financial Intermediation, Elsevier, vol. 49(C).
    6. Fathi Nakai & Tarek Chebbi, 2023. "The informational content of sovereign credit rating: another look," Journal of Asset Management, Palgrave Macmillan, vol. 24(5), pages 353-373, September.

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