Eduardo Cavallo, IADB Andrew Powell, IADB Roberto Rigobon, MIT

Motivation Do 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 upgrades Reduce future interest rate spreads Increase stock markets Appreciate exchange rates Results are quite robustness

Agenda Methodology Data Results Conclusions

Methodology Technically 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 variables Future spread Stock market Exchange rate

Methodology X(t) I(t)

Methodology X(t) R(t)

Methodology X(t) I(t) R(t)

Methodology X(t) I(t) R(t) S(t)

Methodology Idea If the true model is then we can estimate by OLS or using ratings as IV. Test Under 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.

Methodology After 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 event Cumulative returns – to deal with endogeneity and anticipation.

Methodology Typical event

Agenda Methodology Data Results Conclusions

Data Source: Bloomberg Daily information 32 emerging market economies January 1 st 1998 and April 25 th 2007 Macro variables: stock market, interest rate spread, dollar exchange rate, VIX Ratings: Moody, S&P, Fitch – transformed to a numerical scale. Unbalanced panel with ~80k observations

Data

S&P 93 Moody 54 Fitch  Concurrence of credit rating changes (21 days)

Agenda Methodology Data Results Conclusions

Results Pooled 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.

Results Table 4: OLS versus IV

Results Table 5: summary Spreadt+1Stock MarketExchange Rate Standard & Poor's (downgrades + upgrades) Standard & Poor's (downgrades) Standard & Poor's (upgrades) Fitch (downgrades + upgrades) Fitch (downgrades) Fitch (upgrades) Moodys (downgrades + upgrades) Moodys (downgrades) Moodys (upgrades) Standard & Poor's - 5 day window (all) Standard & Poor's - 5 day window (downgrades) Standard & Poor's - 5 day window (upgrades) Standard & Poor's - 20 day window (all) Standard & Poor's - 20 day window (downgrades) Standard & Poor's - 20 day window (upgrades) Standard & Poor's - Without contemporanous change in rating Rejection rate 2 75%63%

Lessons Informational 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

Results Macro variables and S&P S&P upgrades & downgrades SpreadRatingVIX Spreadt *** ***0.006 [0.011][0.0014][0.015] Stock Market-0.205***0.004***-0.104*** [0.011][0.014][0.001] Exchange Rate0.098*** *** [0.008][0.0009][0.010] Δ Spread-0.117*** ***0.029* [0.011][0.001][0.015]

Results Macro variables, Fitch and Moody Fitch upgrades and downgrades Moodys upgrades & downgrades SpreadRatingVIX SpreadRatingVIX Spreadt *** *** 0.855*** **0.040*** [0.010][0.001][0.011] [0.013][0.002][0.015] Stock Market-0.404*** *** ***0.005**-0.140*** [0.016][0.002][0.017] [0.014][0.002][0.016] Exchange Rate0.225*** ***0.033** 0.190*** **0.046*** [0.013][0.002][0.014] [0.010][0.0014][0.012] Δ Spread-0.139*** *** *** **0.070*** [0.010][0.001][0.012] [0.013][0.002][0.015]

Results S&P upgrades and downgrades S&P downgrades S&P upgrades SpreadRatingVIX SpreadRatingVIX Spreadt *** *** *** *** [0.014][0.001][0.017] [0.001][0.022] Stock Market-0.484*** *** **0.002** *** [0.020][0.002][0.025] [0.008][0.001][0.012] Exchange Rate0.196*** *** 0.007**0.002*** [0.018][0.002][0.022] [0.003][0.0003][0.005] Δ Spread-0.109*** ***0.030* *** ***0.027 [0.014][0.001][0.018] [0.017][0.0019][0.024]

Results Typical event

Lessons Informational 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 changes Upgrades 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

Results Does 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.

Results Using outlook in the specification S&P upgrades & downgrades SpreadOutlookVIX Spreadt *** ** [0.009][0.002][0.009] Stock Market-0.363***0.007*** [0.011][0.002][0.010] Exchange Rate0.083*** ***0.015*** [0.006][0.0008][0.005] Δ Spread-0.148*** *** [0.009][0.002][0.0097] S&P downgrades S&P upgrades SpreadOutlookVIX SpreadOutlookVIX 0.876*** *** *0.024* [0.013][0.002][0.014] [0.016][0.001][0.012] *** ***[0.002]0.0159*** [0.013][0.002][0.013] [0.020]0.015***[0.0023] 0.090*** ***0.020** 0.054*** ***0.009** [0.009][0.002][0.009] [0.004][0.001][0.003] *** *** *** **0.045*** [0.013][0.002][0.014] [0.016][0.0018][0.013]

Results Outlook: days between outlook and change.

Results Degree of anticipation

Conclusions Ratings provide information in additional to interest rates Different agencies provide different information Rating upgrades Reduce future interest rate spreads Increase stock markets Appreciate exchange rates All even after controlling for, fixed effects, interest rate and VIX. Robustness Anticipation affects the quantitative results but not the qualitative message Outlooks provide same conclusions