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

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