Capital markets all over the world have undergone fundamental changes in the last twenty years and the most prominent developments have been: disintermediation and securitization, globalization and financial innovations. This process has been accelerated by worldwide deregulation tendencies, as well as progress and global proliferation of transactional data processing and transmission technology. The rational investor disposing of limited time and means for making a decision has been thus confronted with new challenges in a global environment dominated by almost infinite and very complex investment possibilities. Because of limited resources, private clients as well as institutional investors have been increasingly overwhelmed by internally assessing credit risk and have sought for additional evaluations from external specialists in order to build an opinion about the risk and return profile of an obligation . With this background, rating issued by major international rating agencies has come to play a key role in the making of investment decisions and in supervisory regulation. It is especially important in this context to understand the impact of rating changes on capital markets.
The influence of rating changes on bond prices is subject of controversial discussions. Despite the undisputable importance of rating in markets, the debate has been fueled by spectacular insolvencies of high rated companies, such as Enron, WorldCom and Parmalat. Accordingly, measuring and assessing the information content of ratings has been in the United States the object of intense theoretical and empirical research for decades, and the lively ongoing dispute surrounding the topic is far from being concluded. However, analyses on this subject were not initiated outside the US market until the last years. This is especially surprising in the context of international markets, with different accounting and investment regulations, where advantages of rating are even greater. The integration of national financial markets, Basel II impulses and the expansion of rating activities on global level have amplified the necessity of research in this field.
Therefore, it is of paramount importance for the future of the financial sector to thoroughly investigate information content of rating and its impact on securities prices in order to build a solid scientific foundation for this subject and to thus present a reliable frame of reference for the activities of financial markets.
Table of Contents
1 Introduction
1.1 Presentation of the Problem
1.2 Basic Concepts
1.3 Objective and Structure of the Thesis
2 Rating of Corporate Bonds
2.1 Definition and Role of Credit Rating on the Capital Market
2.2 Historical Development
2.3 Rating Classification
2.4 The Rating Process
2.4.1 Organization
2.4.2 Analysis Criteria of Rating Agencies
2.4.3 Qualitative Aspects in the Analysis of Company Risk
2.4.4 Quantitative Aspects in the Analysis of Company Risk
2.5 The Rating Market of Corporate Bonds
3 The Influence of Rating Changes on Bonds
3.1 The Interdependence between Bond Credit Risk and Rating
3.1.1 Bond Ratings and Credit Risk
3.1.2 Theoretical Models for Credit Risk Evaluation
3.1.2.1 Statistical Prediction of Default Likelihood – Stochastic Processes
3.1.2.2 Option-theoretic Approach
3.1.3 Credit Rating Models in Practice
3.1.3.1 Migration Analysis
3.1.3.2 Credit Risk Practical Applications
3.2 Influence of Rating Changes on Bonds in Theory and Practice
3.2.1 Rating in the Neoclassical Financial Theory
3.2.1.1 The Concept of Information Efficient Markets
3.2.1.2 Theoretical Relevance of Rating in Efficient Markets
3.2.1.3 Information Basis of Rating Verdicts
3.2.1.4 Hypotheses about Influence of Rating Changes on Bonds Prices
3.2.2 Rating in Real Capital Markets – Empirical Research
3.2.2.1 Event Studies
3.2.2.2 Presentation of the Conducted Research
3.2.2.3 Conclusions
3.2.3 Explanations of Divergences between Theoretical and Empirical Research
3.2.3.1 The Non-equidistant Character of Rating Verdicts
3.2.3.2 Different Definitions of Risk
3.2.3.3 Investment Regulations and Restrictions
3.3 Significant Examples of Rating Influence on Corporate Bonds
3.3.1 Telefonica
3.3.2 General Motors
3.4 Influence of Rating Changes of a Bond on other Investment Alternatives
4 Contemporary Aspects of Rating Influence on Capital Markets
4.1 Rating in Germany
4.2 Rating of Landesbanken and Savings Bank
4.3 Rating and Basel II
4.4 Possibilities and Limits of Rating
5 Conclusion and Future Perspectives
Objectives and Core Topics
The primary objective of this thesis is to investigate the impact of rating changes on corporate bond prices within financial markets, analyzing both theoretical foundations and empirical evidence to understand how information content affects security valuation.
- The interdependence between credit risk assessment and bond ratings.
- Theoretical models of credit risk and market efficiency.
- Empirical analysis of rating changes using event study methodologies.
- Contemporary developments in the German rating market and Basel II implications.
- Case studies on the market impact of specific rating events (Telefonica, General Motors).
Excerpt from the Book
2.4.1 Organization
The course and organization of a rating process depend on the nature of rating (solicited or unsolicited rating). In the case of unsolicited rating, the analysis process is much shorter, because there is no contact with the evaluated company, therefore only previously released public information is available. Hence, the unsolicited rating quality is usually poorer. The more common solicited rating begins with the issuer’s application. After the initial approach, a team of 4-5 rating analysts is set, and the phase of information gathering starts. This implies company presentations, discussions with the top-management and access to internal, else confidential information, as well as assessment of standard data from annual financial statements or business reports. After a comprehensive analysis of country, sector, company and security risks, a first opinion on the issue emerges. This preliminary rating result is the object of a detailed discussion with the management. The management thus has the chance to present new relevant data or to propose additional guarantees that would improve the rating, before the final result is released. The entire process requires around 90 days. The next two chapters introduce the relevant analysis criteria in the rating process, focusing on the particularities of investigating company risk.
Chapter Summary
1 Introduction: This chapter introduces the problem of credit risk assessment in global markets and outlines the structure and goals of the thesis.
2 Rating of Corporate Bonds: This section provides an overview of the rating process, including analysis criteria, qualitative and quantitative factors, and the current state of the rating market.
3 The Influence of Rating Changes on Bonds: This chapter analyzes the connection between credit risk and ratings, examines the information content within theoretical and empirical frameworks, and provides case studies of rating impacts.
4 Contemporary Aspects of Rating Influence on Capital Markets: This chapter investigates current trends in the German rating market, the impact of Basel II, and the limitations of modern credit rating practices.
5 Conclusion and Future Perspectives: This chapter summarizes the study's findings and suggests directions for future academic research in the field.
Keywords
Credit Rating, Corporate Bonds, Default Risk, Information Efficiency, Capital Markets, Basel II, Event Studies, Credit Spread, Rating Agencies, Financial Regulation, Market Anticipation, Investment Grade, Speculative Grade, Risk Management, Default Probability
Frequently Asked Questions
What is the core focus of this thesis?
The work examines the information content of credit ratings and how changes in these ratings influence the pricing of corporate bonds in global financial markets.
What are the central themes discussed?
Central themes include the methodology behind credit risk evaluation, the relationship between ratings and market efficiency, and the empirical impact of rating adjustments on bond yields.
What is the primary research question?
The study explores whether and to what extent rating changes provide new information that triggers price reactions in bonds, and how these reactions differ across various market environments.
Which scientific methods are employed?
The author utilizes a comprehensive review of theoretical financial literature alongside an analysis of numerous empirical event studies to evaluate market reactions to rating changes.
What topics are covered in the main body of the work?
The main body covers the mechanics of the rating process, the theoretical models for credit risk, an extensive review of empirical research since 1974, and case studies involving Telefonica and General Motors.
Which keywords best characterize this research?
Key terms include credit rating, corporate bonds, default risk, market efficiency, Basel II, and credit spreads.
How does the author explain the impact of the Telefonica takeover?
The author highlights the downgrade of Telefonica as a classic example of an immediate, permanent increase in credit spreads following a company-specific event that led to an aggressive financial policy.
What observation is made regarding General Motors?
The study notes that rating agencies were significantly slower to downgrade General Motors compared to the market's prompt reaction, illustrating issues with rating lags and political/strategic influences on rating decisions.
How does the thesis define market efficiency in the context of ratings?
The work uses the Fama efficient market paradigm, specifically exploring semi-strong efficiency, to assess if rating changes provide information that is not already captured by current market prices.
- Quote paper
- Alina Elena Negrila (Author), 2006, The Influence of Rating Changes on Bonds, Munich, GRIN Verlag, https://www.grin.com/document/58888
