Are Credit Ratings Still Relevant
We examine the pricing relevance of credit rating downgrades when the underlying…rm has Credit Default Swap (CDS) contracts trading on it’s debt. Using a comprehensive sample of credit rating changes from 1998 to 2007, we …find that, after a CDScontract starts trading on a firm’s debt, the …firm’s stock reacts signifi…cantly less to acredit rating downgrade. Firms with traded CDS also have a smaller stock and bondmarket reaction to a credit rating downgrade than …firms without a traded CDS. In addition, CDS spreads explain the cross-sectional variation in primary and secondary bondyields better than credit ratings. Overall, we provide empirical evidence supporting CDSmarket as a viable alternative to credit ratings. An important implication of our studyis that regulators should also focus on improving the transparency in CDS market ratherthan solely addressing the confl‡icts of interest inherent in the business models for ratingagencies.
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…rm has Credit Default Swap (CDS) contracts trading on it’s debt. Using a comprehensive sample of credit rating changes from 1998 to 2007, we …find that, after a CDS
contract starts trading on a firm’s debt, the …firm’s stock reacts signifi…cantly less to a
credit rating downgrade. Firms with traded CDS also have a smaller stock and bond
market reaction to a credit rating downgrade than …firms without a traded CDS. In addition, CDS spreads explain the cross-sectional variation in primary and secondary bond
yields better than credit ratings. Overall, we provide empirical evidence supporting CDS
market as a viable alternative to credit ratings. An important implication of our study
is that regulators should also focus on improving the transparency in CDS market rather
than solely addressing the confl‡icts of interest inherent in the business models for rating
agencies.
