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Courage to Capital? A Model of the Effects of Rating Agencies on Sovereign Debt Roll–over

  • Galina Hale

With the rise of international bond markets in the 1990s, the role of sovereign credit ratings has become increasingly important. In the aftermath of Asian Crises a series of empirical studies on the effects of sovereign ratings appeared. The theoretical literature on the topic, however, remains rather scarce. We propose a model of rating agencies that is an application of global game theory in which heterogeneous investors act strategically. The model is consistent with the main findings of the empirical literature. In particular, it is able to explain the independent effect of sovereign ratings on the cost of debt. Our model also predicts that, in addition to affecting the level of debt roll–over, the mere existence of the rating agency's announcement can increase the magnitude of the response of capital flows to changes in fundamentals. In addition, introducing a rating agency to a market that otherwise would have the unique equilibrium can bring multiple equilibria. The model also allows us to explore the reasons why agencies may over–react to crises, how they can spread financial contagion, and the failure of rating agencies to predict crises. Classification-F34, G14, G15

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Paper provided by IIIS in its series The Institute for International Integration Studies Discussion Paper Series with number iiisdp062.

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Date of creation: 20 Apr 2005
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Handle: RePEc:iis:dispap:iiisdp062
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  19. Kräussl, Roman, 2000. "Sovereign credit ratings and their impact on recent financial crises," CFS Working Paper Series 2000/04, Center for Financial Studies (CFS).
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