Do Credit Agencies Add Value? Evidence from the Sovereign ...

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Do Credit Agencies Add Value? Evidence from the Sovereign ...

  1. 1. Eduardo Cavallo, IADB Andrew Powell, IADB Roberto Rigobon, MIT
  2. 2. Motivation <ul><li>Do credit agencies add informational value to an already well functioning financial market? </li></ul><ul><ul><li>Rating changes are usually anticipated. Hence, they should have been incorporated in interest rates and other financial variables. </li></ul></ul><ul><ul><li>In sovereign debt, does the rating adds information beyond the information already in the interest rate? </li></ul></ul><ul><li>Very difficult to disentangle informational content of credit ratings </li></ul>
  3. 3. What do we do? <ul><li>Evaluate informational content using methodology robust to several misspecification errors </li></ul><ul><li>Evaluate impact of rating changes on stock markets, future spreads, and exchange rates – after controlling for current interest rates and VIX </li></ul>
  4. 4. What we find? <ul><li>Ratings provide information in additional to interest rates </li></ul><ul><li>Rating upgrades </li></ul><ul><ul><li>Reduce future interest rate spreads </li></ul></ul><ul><ul><li>Increase stock markets </li></ul></ul><ul><ul><li>Appreciate exchange rates </li></ul></ul><ul><li>Results are quite robustness </li></ul>
  5. 5. Agenda <ul><li>Methodology </li></ul><ul><li>Data </li></ul><ul><li>Results </li></ul><ul><li>Conclusions </li></ul>
  6. 6. Methodology <ul><li>Technically we are asking if the interest rate is a sufficient statistic for the credit rating. </li></ul><ul><li>We have to allow for misspecification. </li></ul><ul><li>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. </li></ul><ul><li>We evaluate the “sufficient statistic” property of the interest rate trying to explain other financial variables </li></ul><ul><ul><li>Future spread </li></ul></ul><ul><ul><li>Stock market </li></ul></ul><ul><ul><li>Exchange rate </li></ul></ul>
  7. 7. Methodology X(t) I(t)
  8. 8. Methodology X(t) R(t)
  9. 9. Methodology X(t) I(t) R(t)
  10. 10. Methodology X(t) I(t) R(t) S(t)
  11. 11. Methodology <ul><li>Idea </li></ul><ul><ul><li>If the true model is then we can estimate by OLS or using ratings as IV. </li></ul></ul><ul><li>Test </li></ul><ul><ul><li>Under the null hypothesis the OLS estimate and the IV estimate are identical. </li></ul></ul><ul><ul><li>Under the alternative hypothesis, the OLS and IV are different. The OLS is biased because of EIV, but IV is consistent. </li></ul></ul>
  12. 12. Methodology <ul><li>After we have found that the rating has informational content, we run a horse race between interest rates and ratings. </li></ul><ul><ul><li>We estimate in a window surrounding credit rating changes. (+/- 10 days) </li></ul></ul><ul><ul><li>Fixed effect per event </li></ul></ul><ul><ul><li>Cumulative returns – to deal with endogeneity and anticipation. </li></ul></ul>
  13. 13. Methodology <ul><li>Typical event </li></ul>
  14. 14. Agenda <ul><li>Methodology </li></ul><ul><li>Data </li></ul><ul><li>Results </li></ul><ul><li>Conclusions </li></ul>
  15. 15. Data <ul><li>Source: Bloomberg </li></ul><ul><li>Daily information </li></ul><ul><li>32 emerging market economies </li></ul><ul><li>January 1 st 1998 and April 25 th 2007 </li></ul><ul><li>Macro variables: stock market, interest rate spread, dollar exchange rate, VIX </li></ul><ul><li>Ratings: Moody, S&P, Fitch – transformed to a numerical scale. </li></ul><ul><li>Unbalanced panel with ~80k observations </li></ul>
  16. 16. Data
  17. 17. Data 21 12 5 15 <ul><li>Concurrence of credit rating changes (21 days) </li></ul>
  18. 18. Agenda <ul><li>Methodology </li></ul><ul><li>Data </li></ul><ul><li>Results </li></ul><ul><li>Conclusions </li></ul>
  19. 19. Results <ul><li>Pooled all credit rating events. </li></ul><ul><li>Fixed effects for each event. </li></ul><ul><li>Analyze window of 21 days surrounding credit rating change. </li></ul><ul><li>Use cumulative returns. </li></ul><ul><li>We are not concerned with interpretation of coefficient. No attempt to disentangle channel of propagation. </li></ul>
  20. 20. Results <ul><li>Table 4: OLS versus IV </li></ul>
  21. 21. Results <ul><li>Table 5: summary </li></ul>  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 rate 2 75% 63% 63%
  22. 22. Lessons <ul><li>Informational content </li></ul><ul><ul><li>Around credit rating changes, ratings provide information beyond interest rates </li></ul></ul><ul><ul><ul><li>EIV interpretation allows for a robust methodology </li></ul></ul></ul><ul><ul><ul><li>Robust to specification changes </li></ul></ul></ul><ul><ul><ul><li>Even though they are anticipated </li></ul></ul></ul>
  23. 23. Results <ul><li>Macro variables and S&P </li></ul>  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]
  24. 24. Results <ul><li>Macro variables, Fitch and Moody </li></ul>  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]
  25. 25. Results <ul><li>S&P upgrades and downgrades </li></ul>  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]
  26. 26. Results <ul><li>Typical event </li></ul>
  27. 27. Lessons <ul><li>Informational content </li></ul><ul><ul><li>Around credit rating changes, ratings provide information beyond interest rates </li></ul></ul><ul><ul><ul><li>EIV interpretation allows for a robust methodology </li></ul></ul></ul><ul><ul><ul><li>Robust to specification changes </li></ul></ul></ul><ul><ul><ul><li>Even though they are anticipated </li></ul></ul></ul><ul><li>Rating changes </li></ul><ul><ul><li>Upgrades </li></ul></ul><ul><ul><ul><li>Decrease future spreads (0.7% per notch) </li></ul></ul></ul><ul><ul><ul><li>Increase stock market (0.2% per notch) </li></ul></ul></ul><ul><ul><ul><li>Appreciate real exchange rate (0.2% per notch) </li></ul></ul></ul><ul><ul><li>Downgrades </li></ul></ul><ul><ul><ul><li>Decrease future spreads (0.6% per notch) </li></ul></ul></ul><ul><ul><ul><li>No impact on stock markets </li></ul></ul></ul><ul><ul><ul><li>No impact on exchange rates </li></ul></ul></ul>
  28. 28. Results <ul><li>Does changes in asset class have larger impact? </li></ul><ul><ul><li>We find that changing the asset class has no additional effect for the rating variable. </li></ul></ul><ul><li>What about outlook changes? </li></ul><ul><ul><li>Replicate the results for outlook. </li></ul></ul><ul><ul><li>Estimate degree of anticipation using the outlook change prior to the rating change. </li></ul></ul>
  29. 29. Results <ul><li>Using outlook in the specification </li></ul>  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]
  30. 30. Results <ul><li>Outlook: days between outlook and change. </li></ul>
  31. 31. Results <ul><li>Degree of anticipation </li></ul>
  32. 32. Conclusions <ul><li>Ratings provide information in additional to interest rates </li></ul><ul><ul><li>Different agencies provide different information </li></ul></ul><ul><li>Rating upgrades </li></ul><ul><ul><li>Reduce future interest rate spreads </li></ul></ul><ul><ul><li>Increase stock markets </li></ul></ul><ul><ul><li>Appreciate exchange rates </li></ul></ul><ul><ul><li>All even after controlling for, fixed effects, interest rate and VIX. </li></ul></ul><ul><li>Robustness </li></ul><ul><ul><li>Anticipation affects the quantitative results but not the qualitative message </li></ul></ul><ul><ul><li>Outlooks provide same conclusions </li></ul></ul>

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