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Optimal Credit Ratings

Author

Listed:
  • SEBASTIAN HERZOG

    (University of Mannheim, L 5, 2, D-68131 Mannheim, Germany)

  • CHRISTIAN KOZIOL

    (WHU — Otto Beisheim School of Management, Burgplatz 2, D-56179 Vallendar, Germany)

  • TIM THABE

    (Goldman Sachs International, Peterborough Court, 133 Fleet Street, London EC4A 2BB, United Kingdom)

Abstract

In this paper, we show that an individual optimal credit rating exists for firms and empirically test whether firms strive to achieve their optimal rating. For this purpose, we consider the structural model by Leland [12], which balances the benefits of debt in the form of the tax-deductibility of interest payments against bankruptcy costs in order to obtain the optimal rating. Testable implications for both firms which have implemented their optimal rating and firms with non-optimal ratings are deduced. An empirical test with 420 firms contained in the S&P 500 Index indicates that all factors which theoretically drive optimal ratings also affect the observed rating in the predicted way. In line with our theory, observed ratings can be considerably better explained if, in addition to the traditional factors such as leverage and firm size, a proxy for bankruptcy costs and the default probability related to the optimal rating is considered. These findings suggest that U.S. firms contained in the S&P 500 Index strive to achieve their optimal credit ratings.

Suggested Citation

  • Sebastian Herzog & Christian Koziol & Tim Thabe, 2008. "Optimal Credit Ratings," International Journal of Theoretical and Applied Finance (IJTAF), World Scientific Publishing Co. Pte. Ltd., vol. 11(02), pages 225-247.
    • Handle: RePEc:wsi:ijtafx:v:11:y:2008:i:02:n:s0219024908004786
    DOI: 10.1142/S0219024908004786
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    References listed on IDEAS

    as
    1. Acharya, Viral & Bharath, Sreedhar T & Srinivasan, Anand, 2003. "Understanding the Recovery Rates on Defaulted Securities," CEPR Discussion Papers 4098, C.E.P.R. Discussion Papers.
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