Ratings are used almost universally by investors, bankers, supervisors, and regulators as the relevant risk metric. The familiarity of markets with these letter ratings has probably encouraged investors to add these instruments to their portfolios, and has helped to establish the market for various ABS products in the first place. While it was widely known that securitization notes represent tranches, rather than shares, of underlying asset portfolios, most investors were confident that letter ratings (e.g. AAA, AA, A and so on) had the same meaning for ABS notes and for corporate bonds. Consistent with this claim, we have not found a publication of any of the three leading agencies, explaining whether and how ABS ratings differ in content from those used in bond markets. Apparently, market participants, both investors and originators, tended to believe that their bond market experience and the rating methodology, known for a very long time, could safely be carried over to the markets for asset backed securities. In an analogous manner, supervisors put great emphasis on agency ratings when assessing the risk level of portfolios containing such asset backed instruments. The most prominent example is the external ratings based approach in the Basel 2 regulatory framework.
The aim of this paper is to contribute to the literature on market efﬁciency by analyzing, through a VECM, the relationship between changes in bond spreads (BS), changes in CDS spreads (CDS), and changes in stock market implied credit spreads (ICS). The analysis is based on the same proprietary database on BS, CDS and ICS con- sidered by Forte (2008). More speciﬁcally, BS and CDS are related to the ICS generated by a modiﬁed version of Leland and Toft’s (1996) structural credit risk model, and a novel calibration proce- dure for the model parameters. Our analysis differs from those of Blanco et al. (2005) and Zhu (2004, 2006), in that we introduce the stock market as a third market into the analysis. It also differs from the analyses of Longstaff et al. (2003) and Norden and Weber (2005), because we deal with credit spreads obtained from the stock market as well as from CDS and bond markets. In this sense it is, as far as we know, the ﬁrst work in which a strict price discov- ery analysis is performed for the three markets simultaneously.
Table 4 describes 20 bonds portfolio by credit ratings and its relation in daily regression. Based on Scholes & William (1977) and as in Cornell & Green (1991), the result shows the sum of the coef- ficients as opposed to individual coefficients since interpretation of the individual lagged coefficisnets is inappropriate in this context. Results are insensi- tive to the inclusion of additional lags (or leads) of any variables. The return on the daily bond portfo- lio in equation (4) is significantly positively related to the Lehmann Index Return (“âL = 0.58), as well as to the daily S&P 500 index return (“âL = 0.49). Regression (5) substitutes the default-free bond return for the Lehmann index return. Although the coefficient is somewhat lower, this variable more closely measures the interest rate risk of the spe- cific FIPS securities. Market-wide information is reflected in the coefficient for the S&P 500 return which is slightly greater in Regression (5).
Bond and Goldstein ( 2015 ) (BG in short) analyze a related CARA-normal noisy REE model with policy maker, but in their setting the asset value does not directly depend on θ, only indirectly via the government action that depends on the state θ. Hence, in their model, traders use their information to predict the government’s information and action rather than the state. For this reason, their implications for transparency are different, because as soon as the government’s information is public in their setting, there is no need for traders to trade on their information, so price informativeness suffers. In the setup here, the conclusions on transparency are more nuanced, and transparency typically helps the policy maker to obtain more information from the market, while there are some cases where transparency is undesirable. Moreover, the setup in BG does not allow for self-defeating prophecies, so the present paper contributes by analyzing if and when these can arise, which makes a major qualitative difference when equilibrium non-existence is interpreted as breakdown of information revelation. This is especially true in my case of an uninformed policy maker with non-linear policy rules, which allow for a larger set of applications.
As interest rates hardly reflect the economic reality of OECD countries, and monetary policies are failing to boost Inflation, the interest for Inflation protections has increased among investors, boosting the demand for Inflation-linked derivatives. This increase in demand has only partially been fulfilled by a slight increase in inflation-indexed bond issues. The primary Inflation market is often too small to hedge the demand of Inflation-linked derivatives. On the other hand the commodities derivatives market is large enough to fill the gap and some sections of the commodities market are very liquid. From a hedging perspective, cross-hedging of Inflation- linked derivatives with commodities seems a promising path. This would lead to the creation of CI based derivatives, which are potentially very attractive contracts for investors looking to hedge their long-term inflation position (such as pension funds for instance).
rely on a “comprehensive credit rating” which combines two different types of rat- ing announcements — actual rating changes and watch, or review, changes — into a single scale. Their identification therefore depends on rather strong additional assumptions on the relative informationalcontent of reviews and ratings. We, how- ever, focus solely on the class of actual rating changes. In detail, we test whether a country’s sovereign bonds react more heavily to upgrades or downgrades elsewhere when those are “large” — ie, when the actual rating changes by two notches or more. The group of “small” one-notch changes serves as the counterfactual during that exercise. At the same time, we explicitly allow for differences in the informa- tional content of sovereign rating changes by controlling for watchlistings that may build anticipation in the market. Moreover, we are also able to account for the fact that an announcement is often followed by a similar one from a different agency soon after, which may further influence the reception of the later announcements. 2
Second, during the period under investigation, Greek financial reporting practices were blamed for excessive earnings management (Leuz et al., 2003; Garcia-Osma and Pope, 2011) and fraudulent reporting practices (Caramanis and Lennox, 2008). While several measures to restore investor confidence were initiated, such as the establishment of a new Oversight Board in 2003 and the early application of IFRSs under the Law 2992/2002, the local press and interviews with investment bankers revealed that investors in Greece used alternative channels other than annual reports to glean corporate information (including credit ratings and analyst recommendations). Hence, Greece provides an interesting setting for testing the informational role of credit ratings in association with earnings announcement releases. To isolate the effect of the country’s sovereign debt crisis, which severely affected corporate creditworthiness and profitability, we focus our attention on the period just prior to the debt crisis, when market participants evaluated company fundamentals and corporate announcements without serious behavioral biases.
To the best of our knowledge, Manaster and Rendleman (1982) are the first authors who have studied empirically the conjecture that option prices may contain useful information for the future values of the underlying asset. Based on the Black and Scholes (1973) model they computed the price of the stock that equates the theoretical value of the option with its market price, i.e. the implied stock price. They argued that the Black and Scholes (1973) approach suggests that the implied price should be the value of the underlying stock for which a continuously revised option-bond portfolio would be a perfect substitute for the stock. Therefore, in the case where implied stock prices differ significantly from observed stock prices, traders will arbitrage it away, and as a result implied and observed stock prices will converge. The authors argue that the investment vehicle that provides the greatest liquidity, the lowest trading costs, and the least restrictions will play the predominant role in the market’s determination of the equilibrium stock price and discuss why the option markets are superior to the stock markets in these respects. The empirical analysis is undertaken in the context of an investment strategy that ranks stocks according to the magnitude of the discrepancy between the traded and the implicit stock price and forms portfolios which are held for one day. The results indicate that a portfolio of stocks in the top quintile of percentage discrepancies, i.e. the implicit price is higher than the actual price, outperforms a portfolio of stocks in the bottom quintile of discrepancies by an economical and statistically significant 0.065% return (Table V, p. 1054). 1
The first goal defined for this work is to test the information content and relevance of sovereign debt ratings, that is, whether changes in these rating levels influence the Portuguese Treasury bond yields. Some authors mentioned in section one (such as Brooks et al., 2004; Kräussl, 2005; Kiff, et al., 2012) claim that the information analysed by rating agencies is public and, therefore, efficient markets will anticipate the rating changes, fully incorporating these expectations into market prices prior to the rating change announcement. On the other hand, International Organization of Securities Commission – IOSCO (2008) claims that even though the information gathered by the rating agencies is public, the cost of access and time needed for analysis may be too high for most investors. This makes these ratings relevant and new information for the markets, which influences the performance of financial assets. In order to study this issue, the following hypothesis is tested:
Several recent papers that examine the stock-bond relation are closely related to mine. Connolly, Stivers, and Sun (2003) show that the correlation between daily returns on stocks and bonds varies substantially over the 1986-2000 period. 4 They also find that this variation is related to the general level of uncertainty in the equity market; days of low uncertainty are associated with a positive stock-bond return correlation over the following month, while days of high uncertainty are more likely to be associated with a negative correlation. Fleming, Kirby, and Ostdiek (1998) document informational linkages between the stock, bond, and money markets using daily futures returns. And Chordia, Sarkar, and Subrahmanyam (2003) show that innovations to bid-ask spreads in the stock and bond markets are correlated during the 1990's. They link this variation in “micro” liquidity to variation in “macro” liquidity through monetary policy and mutual fund flows. I contribute to this literature by examining the importance of order flow in this relation across markets. I show that order flow has time- varying cross-market impacts, and that this time variation seems to be related to “macro” level uncertainty in the economy. The results indicate that increased market-wide
Our study differs from theirs in several ways. Firstly, it is based on a larger and more up-to-date sample of up to 73 countries for the 1994–2011 period. Secondly, their dataset only includes information of ratings by Standard & Poor’s (S&P), which risks biasing estimation results since, as we demonstrate, a rating action by one agency is often foreshadowed or closely followed by a similar action from another rating agency. Ignoring the informationalcontent of rating actions by other agencies may therefore prove to be problematic. Thirdly, their identification of spillovers uses a “comprehensive credit rating”, which combines actual rating changes and credit watch, or review, changes into a single 17-notch scale. Hence, they make additional assumptions on the relative informationalcontent of reviews and ratings. In this study, we exploit the variation in our sample to focus solely on the class of actual rating changes and their relative strength as the only observable difference between them. At the same time, we do allow for differences in the informationalcontent of sovereign upgrades and downgrades by controlling for watchlistings that may build anticipation by foreshadowing actual future rating changes. Finally, due to lack of data, Gande and Parsley (2005) only use an indirect measure of trade integration. Relying on bilateral data, we find trade to be remarkably unrelated to the strength of spillovers.
Echoing a casual reading of Hickman (1958) that has had some success, West (1973) exhibits an over-inflation of non-investment grade corporate bond yields in 1949 and 1953 as a lasting and straightforward effect of the 1938 regulation of bank investment. It is then tempting to conclude that the public use of ratings would have altered how investors value bonds. Yet, how come other developments did not challenge such a straightforward effect? Proponents of a “regulatory induced” premium need to investigate why arbitrage by unconstrained investors has not taken place. For example, up to 1953 and under certain conditions, insurers could invest in bonds below the regulatory threshold on which West (1973) and others focused. Of course, one answer may be that these unconstrained investors did not have a sufficient market power to influence a structurally altered market place. Glenn (1976) then introduces a theoretical discussion focusing on the prohibition of short-sales. This burden of proof aside, this paper came back on West (1973) with the help of modern regression routines and did not find evidence of a “regulatory premium” for non-investment grade bond. This paper then criticizes an alleged straightforward effect of rating driven regulations introduced in the 1930’s. This contribution is similar to Fridson (1994, pp. 49-50) showing how readers inferring a similar effect from Hickman (1958) were misled (see, supra, section 2).
This study contributes to the literature by providing further evidence on how the arrival of common information in the market place is incorporated into the prices of bonds and the issuing firms’ stocks. In particular, I use the Barclays bond indices data with a wide spectrum of credit ratings to examine the relative informational efficiency of bonds and stocks issued by the same firms. I use a bivariate VAR to investigate the lead-lag relation between the returns of the bonds and those of the issuing firms’ stocks. My findings indicate that the daily stock returns lead the daily bond returns for the Investment Grade, Aa, A, Baa, High Yield, Ba, B, and Caa rated bond portfolios but not for the safest and the least safe bond portfolios that are rated Aaa and Ca-D. This finding indicates that the stock market is more efficient relative to the bond market in incorporating common information. In general, my results are consistent with the results of Downing et al., (2009), Hong et al. (2012), and Gebhardt et al. (2005). However, I also find that the relative efficiency of the bond and stock markets varies with the creditworthiness of the bond portfolio examined. Furthermore, my results and inferences are based on data from bond indices, which means that they should be interpreted with caution. For example, Downing et al., (2009)
The relationship between ratings, economic indicators, and yields of municipal bonds has been a traditional subject of interest for both academics and practitioners. For instance, Jantscher (1970) analyzes the differences in interest rates between local governments which have maintained a constant credit rating and issuers which have been downgraded, has been the first author to study the relationship between ratings and municipal bond yields. He finds that yield differentials between local authorities with different ratings are partly explained by the rating assessments from rating agencies and partly by the independent credit analysis done by investors, which Jantscher called “market rating”. Later on, Rubinfeld (1973) applied a two-stage regression model where local governments’ bond yields are explained by credit ratings and a set of indicators aimed to quantify the creditworthiness of the issuer (Jantscher’s market rating). He first obtained a rating score variable (to convert the letter assessments Aaa, Aa, Baa etc. into numerical values) and then regresses it together with a set of financial, socio-economic and market variables. He obtains that published credit ratings have an independent effect beyond the market’s evaluation of the financial status of the rated municipality, meaning that the credit assessments provided by rating agencies carry additional information with respect to the independent market evaluation based on the publicly available observable variables. Also, Ingram et al. (1983) examined the information content of municipal bond rating changes by evaluating municipal bond price adjustments during the period surrounding a rating change. Testing a sample of US municipal bonds, they find that rating changes do have an impact on yields during the month of the change. As expected, upgraded bonds experience a decrease in yields while downgraded ones face a yield rise.
Many previous studies use bond prices or yields in quantifying the informationalcontent of credit ratings. However our research makes use of CDS spreads as they are already credit spreads. Hull et all (2004) note that to obtain credit spreads using bonds, yields and prices must be adjusted which requires an assumption regarding an appropriate risk free rate. They conjecture that probabilities calculated from historical data are usually less than the default probabilities backed out from bond prices. This is consistent with earlier work done on this subject. For example Altman (1989) investigates bond mortality and performance rates. He finds that corporate bonds, adjusted for impact of defaults, have a significant positive return spread above the US Treasury rates. Possible explanations for this discrepancy include; mispricing of corporate debt issues, liquidity risk and interest rate or reinvestment risk. Altman argues that some institutional investors can only legally buy investment grade bonds. Thus non- investment grade bonds could see reduced demand and inflated prices. Therefore CDS spreads should give a better measure of default probability and credit worthiness than bond prices or yields.
As a result of this study, the interpretation and discussion of the findings for Chapter 4 are presented in this chapter. The research question that is pivotal to this study was: Does the form of local city government impact municipal bondratings, particularly does the council-manager form of local government have better municipal bondratings than other forms of local government? The theory is that city managers administer more professional cities. These city managers have demonstrated more budgetary sound practices and contract negotiating skills due to their professional training than those officials in other forms of local government. According to the data obtained from this research, there appears to be agreement that the form of local government in municipalities does influence the city’s bond rating values awarded. There were slightly higher bondratings values observed from the city manager municipal data, for these local governments received higher municipal bondratings than the mayor/other forms of local government. This finding could aid more municipalities in their decisions, as many determine what form of local government may work better for awarding better bondratings. The statistical findings presented in this research only support the discipline of public administration in United States’ municipalities. This study may increase the need for more public administration students. For public administrators may be in higher demand in the future, if the trend continues of
The general consensus across both the academic literature and practitioner research is that there exists a positive correlation between stock and bond returns, but a substantial amount of variation within that relation is also present. For example, the Pimco quantitative research document (Johnson et al., 2013) documents an average correlation of 10% for US assets over the period 1927 to 2012 but with a variability that ranges from −93% to +86%. As noted in this document, the negative correlations arise from changes in investor risk appetite, most notably referred to as a flight-to-safety. This occurs when investors perceive heightened risk and so shun risky equity in favour of safer debt. This paper argues that this time-varying correlation can therefore be utilised as a measure of risk and will thus have predictive power for future movements in both asset returns themselves and the wider economy. A decline in the stock-bond correlation indicates that the two asset classes are moving apart and this can act as a market timing signal for investors. Using the correlation as a predictor, investors should be able to construct improved stock and bond portfolios. Beyond this, a negative correlation implies that investor outlook for future macroeconomic conditions are poor, indicating a future downturn. Such information therefore, would be of use to policy-makers, providing a leading indicator measure.
Our empirical evidence suggests that the effect that the informationalcontent of unconventional monetary policy has on the precious metals markets is country specific. The Bank of Japan affects positively metals’ returns dampening their volatility, in contrast to the European Central Bank which causes destabilization effects mainly due to the heterogeneous expectations of investors within these markets. These findings imply that the ECB unconventional monetary easing informationalcontent opposes its stated mission adding uncertainty in precious metals markets. The rest of the paper consists of the data and the econometric methodology, the presentation of the empirical findings and a concluding discussion of the paper.
approach incorporates non-common priors into incomplete-information models by assuming that privately informed traders agree to disagree about the precision of traders’ private information. Daniel, Hirshleifer and Subrahmanyam (1998, 2001) and Odean (1998), for example, show how traders’ overconﬁdence about the precision of their private information can increase trading volume. Similarly, Odean (1998), Banerjee, Kaniel and Kremer (2009), Banerjee and Kremer (2010), and Banerjee (2011) show that when traders downplay the precision of one another’s private signals— which we call dismissiveness—volume also increases. In this second class of agreeing-to-disagree models, the presence of private information infuses market prices with information content, and traders are assumed to fully invert market prices to uncover hidden information. Both type of agreeing-to-disagree models depict traders who recognize their disagreements in beliefs and trade based on them.