Eduardo Cavallo, IADBAndrew Powell, IADB

Roberto Rigobon, MIT

MotivationDo credit agencies add informational value to

an already well functioning financial market?Rating changes are usually anticipated. Hence,

they should have been incorporated in interest rates and other financial variables.

In sovereign debt, does the rating adds information beyond the information already in the interest rate?

Very difficult to disentangle informational content of credit ratings

What do we do?Evaluate informational content using

methodology robust to several misspecification errors

Evaluate impact of rating changes on stock markets, future spreads, and exchange rates – after controlling for current interest rates and VIX

What we find?Ratings provide information in additional to

interest rates

Rating upgradesReduce future interest rate spreadsIncrease stock marketsAppreciate exchange rates

Results are quite robustness

AgendaMethodologyDataResultsConclusions

MethodologyTechnically we are asking if the interest rate is a

sufficient statistic for the credit rating.

We have to allow for misspecification.

To test this hypothesis we assume that there is an underlying fundamental for the economy, and interest rates and credit ratings are imperfect measures of it.

We evaluate the “sufficient statistic” property of the interest rate trying to explain other financial variablesFuture spreadStock marketExchange rate

MethodologyX(t)

I(t)

MethodologyX(t)

R(t)

MethodologyX(t)

I(t)

R(t)

MethodologyX(t)

I(t)

R(t)

S(t)

MethodologyIdea

If the true model is

then we can estimate

by OLS or using ratings as IV.

TestUnder the null hypothesis the OLS estimate and the IV

estimate are identical. Under the alternative hypothesis, the OLS and IV are

different. The OLS is biased because of EIV, but IV is consistent.

𝑖𝑡 = 𝑖0 +𝜃𝑥𝑡

𝑟𝑡 = 𝑟0 +𝛼𝑥𝑡 +𝜂𝑡

𝑠𝑡 = 𝑠0 + 𝛽𝑥𝑡 + 𝜇𝑡

𝑠𝑡 = 𝑐0 +𝑏𝑖𝑡 +𝜑𝑡

MethodologyAfter we have found that the rating has

informational content, we run a horse race between interest rates and ratings.

We estimate in a window surrounding credit rating changes. (+/- 10 days)

Fixed effect per eventCumulative returns – to deal with endogeneity

and anticipation.

tiitij

titi VIXriSti ,,,, ,

MethodologyTypical event

AgendaMethodologyDataResultsConclusions

DataSource: BloombergDaily information 32 emerging market economiesJanuary 1st 1998 and April 25th 2007Macro variables: stock market, interest rate

spread, dollar exchange rate, VIXRatings: Moody, S&P, Fitch – transformed to

a numerical scale.Unbalanced panel with ~80k observations

Data Variable Obs Mean Std. Dev.

Rating 3045 8.51 3.80Spread 2533 0.01 0.17

Stock Market 2438 -0.01 0.10Exchange Rate 2996 0.01 0.06

VIX 3045 -0.01 0.13

Variable Obs Mean Std. Dev.

Rating 2331 9.14 3.36Spread 2159 0.03 0.16

Stock Market 1768 0.00 0.10Exchange Rate 2265 0.02 0.09

VIX 2331 0.00 0.13

Variable Obs Mean Std. Dev.

Rating 1890 9.13 3.31Spread 1718 0.03 0.18

Stock Market 1582 -0.02 0.11Exchange Rate 1832 0.01 0.07

VIX 1890 0.02 0.14

Standard & Poor's

Fitch

Moody's

Data

21 12

5

15

Concurrence of credit rating changes (21 days)

AgendaMethodologyDataResultsConclusions

ResultsPooled all credit rating events.Fixed effects for each event.Analyze window of 21 days surrounding

credit rating change.Use cumulative returns.We are not concerned with interpretation of

coefficient. No attempt to disentangle channel of propagation.

ResultsTable 4: OLS versus IV

Spread t+1 Stock Market Exchange RateOLS 0.906*** -0.217*** 0.100***

[0.010] [0.009] [0.007]IV 1.008*** -0.280*** 0.109***

[0.025] [0.024] [0.017]Hausman Test (Ch^2) 20.13 8.03 0.33

P-value 0.001 0.018 0.848

ttt bics 0

ResultsTable 5: summary

  Spreadt+1 Stock Market Exchange Rate

Standard & Poor's (downgrades + upgrades) 0.001 0.018 0.848

Standard & Poor's (downgrades) 0.010 0.800 0.436

Standard & Poor's (upgrades) 0.001 0.140 0.001

Fitch (downgrades + upgrades) 0.430 0.600 0.001

Fitch (downgrades) 0.960 0.001 0.001

Fitch (upgrades) 0.190 0.001 0.031

Moodys (downgrades + upgrades) 0.066 0.061 0.082

Moodys (downgrades) 0.355 0.053 0.001

Moodys (upgrades) 0.078 0.009 0.001

Standard & Poor's - 5 day window (all) 0.001 0.078 0.771

Standard & Poor's - 5 day window (downgrades) 0.001 0.770 0.018

Standard & Poor's - 5 day window (upgrades) 0.100 0.017 0.001

Standard & Poor's - 20 day window (all) 0.001 0.660 0.850

Standard & Poor's - 20 day window (downgrades) 0.001 0.001 0.670

Standard & Poor's - 20 day window (upgrades) 0.001 0.068 0.001

Standard & Poor's - Without contemporanous change in rating 0.001 0.100 0.250

Rejection rate2 75% 63% 63%

LessonsInformational content

Around credit rating changes, ratings provide information beyond interest rates EIV interpretation allows for a robust methodology Robust to specification changes Even though they are anticipated

ResultsMacro variables and S&P

  S&P upgrades & downgrades

  Spread Rating VIX

Spreadt+1 0.884*** -0.006*** 0.006

  [0.011] [0.0014] [0.015]

Stock Market -0.205*** 0.004*** -0.104***

  [0.011] [0.014] [0.001]

Exchange Rate 0.098*** -0.0005 0.045***

  [0.008] [0.0009] [0.010]

Δ Spread -0.117*** -0.006*** 0.029*

  [0.011] [0.001] [0.015]

ResultsMacro variables, Fitch and Moody

  Fitch upgrades and downgrades   Moodys upgrades & downgrades

  Spread Rating VIX   Spread Rating VIX

Spreadt+1 0.863*** -0.002 0.036***   0.855*** -0.004** 0.040***

  [0.010] [0.001] [0.011]   [0.013] [0.002] [0.015]

Stock Market -0.404*** 0.002 -0.132***   -0.297*** 0.005** -0.140***

  [0.016] [0.002] [0.017]   [0.014] [0.002] [0.016]

Exchange Rate 0.225*** -0.009*** 0.033**   0.190*** -0.003** 0.046***

  [0.013] [0.002] [0.014]   [0.010] [0.0014] [0.012]

Δ Spread -0.139*** -0.001 0.064***   -0.147*** -0.004** 0.070***

  [0.010] [0.001] [0.012]   [0.013] [0.002] [0.015]

ResultsS&P upgrades and downgrades

  S&P downgrades   S&P upgrades

  Spread Rating VIX   Spread Rating VIX

Spreadt+1 0.894*** -0.006*** 0.013   0.876*** -0.007*** -0.003

  [0.014] [0.001] [0.017]   [0.017] [0.001] [0.022]

Stock Market -0.484*** -0.002 -0.067***   -0.018** 0.002** -0.085***

  [0.020] [0.002] [0.025]   [0.008] [0.001] [0.012]

Exchange Rate 0.196*** -0.003 0.089***   0.007** 0.002*** -0.006

  [0.018] [0.002] [0.022]   [0.003] [0.0003] [0.005]

Δ Spread -0.109*** -0.006*** 0.030*   -0.124*** -0.006*** 0.027

  [0.014] [0.001] [0.018]   [0.017] [0.0019] [0.024]

ResultsTypical event

LessonsInformational content

Around credit rating changes, ratings provide information beyond interest rates EIV interpretation allows for a robust methodology Robust to specification changes Even though they are anticipated

Rating changesUpgrades

Decrease future spreads (0.7% per notch) Increase stock market (0.2% per notch) Appreciate real exchange rate (0.2% per notch)

Downgrades Decrease future spreads (0.6% per notch) No impact on stock markets No impact on exchange rates

ResultsDoes changes in asset class have larger

impact?We find that changing the asset class has no

additional effect for the rating variable.What about outlook changes?

Replicate the results for outlook.Estimate degree of anticipation using the

outlook change prior to the rating change.

ResultsUsing outlook in the specification

  S&P upgrades & downgrades

  Spread Outlook VIX

Spreadt+1 0.856*** -0.0005 0.022**

  [0.009] [0.002] [0.009]

Stock Market -0.363*** 0.007*** -0.009

  [0.011] [0.002] [0.010]

Exchange Rate 0.083*** -0.005*** 0.015***

  [0.006] [0.0008] [0.005]

Δ Spread -0.148*** -0.0009 0.0536***

  [0.009] [0.002] [0.0097]

S&P downgrades   S&P upgrades

Spread Outlook VIX   Spread Outlook VIX

0.876*** 0.002 0.02   0.808*** -0.003* 0.024*

[0.013] [0.002] [0.014]   [0.016] [0.001] [0.012]

-0.400*** -0.001 -0.017   -0.283*** [0.002] 0.0159***

[0.013] [0.002] [0.013]   [0.020] 0.015*** [0.0023]

0.090*** -0.007*** 0.020**   0.054*** -0.002*** 0.009**

[0.009] [0.002] [0.009]   [0.004] [0.001] [0.003]

-0.128*** 0.002 0.059***   -0.195*** -0.004** 0.045***

[0.013] [0.002] [0.014]   [0.016] [0.0018] [0.013]

ResultsOutlook: days between outlook and change.

ResultsDegree of anticipation

S&P - Outlook Anticipation to Change in Rating (Rating Changes on day 21)

-20%

-15%

-10%

-5%

0%

5%

10%

15%

20%

1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35 37 39 41

Spread less than 60 days Spread between 60 and 220 days Spreads more than 220 days

ConclusionsRatings provide information in additional to interest rates

Different agencies provide different information

Rating upgradesReduce future interest rate spreads Increase stock marketsAppreciate exchange rates

All even after controlling for, fixed effects, interest rate and VIX.

RobustnessAnticipation affects the quantitative results but not the

qualitative messageOutlooks provide same conclusions