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Credit Rating Downgrade Risk on Equity Returns

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  • Periklis Brakatsoulas

    () (Institute of Economic Studies, Faculty of Social Sciences, Charles University Opletalova 26, 110 00, Prague, Czech Republic
    Institute of Information Theory and Automation of the Czech Academy of Sciences, Pod Vodarenskou vezi 4, 182 00 Prague 8, Czech Republic)

  • Jiri Kukacka

    () (Institute of Economic Studies, Faculty of Social Sciences, Charles University Opletalova 26, 110 00, Prague, Czech Republic)

Abstract

We develop a four-factor model intended to capture size, value, and credit rating transition patterns in excess returns for a panel of predominantly mid- and large-cap entities. Using credit transition matrices and rating histories from 48 US issuers, we provide evidence to support a statistically significant negative downgrade risk premium in excess returns, suggesting that stocks at higher risk of failure tend to deliver lower returns. The performance of the model remains robust across several estimation methods. Panel Granger causality test results indicate that there indeed is a Granger-causal relationship from credit rating transition probabilities to excess returns. Our paper thus provides a new methodology to generate firm-level downgrade probabilities and the basis for further empirical validation and development of Fama-French-type models under financial distress.

Suggested Citation

  • Periklis Brakatsoulas & Jiri Kukacka, 2020. "Credit Rating Downgrade Risk on Equity Returns," Working Papers IES 2020/13, Charles University Prague, Faculty of Social Sciences, Institute of Economic Studies, revised May 2020.
  • Handle: RePEc:fau:wpaper:wp2020_13
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    File URL: http://ies.fsv.cuni.cz/sci/publication/show/id/6244/lang/cs
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    Keywords

    Asset pricing; credit risk; panel data; stock returns; transition matrices.;

    JEL classification:

    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading
    • G41 - Financial Economics - - Behavioral Finance - - - Role and Effects of Psychological, Emotional, Social, and Cognitive Factors on Decision Making in Financial Markets

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