The effects of changing in credit ratings on equity returns

Abstract

As the link between the credit risk and return patterns on equity returns has increasingly become an area of interest. In this thesis I investigate the existence of a systematic relationship between credit ratings as the indicators of credit risk and on equity returns. The credit rating is used by individuals and entities that purchase the bonds issued by companies and governments to determine the likelihood that the government will pay its bond obligations. Particularly this study investigates the announcement effect on equity returns associated with credit rating changes. Additionally this study contributes to the understanding of the observed announcement effects by relating them to different components of credit rating process. This study is based on a sample of credit rating changes from 2008 to 2012 by different companies listed in Islamabad stock exchange. This study find that downgrade announcements on average are associated with negative abnormal share price reactions and no systematic reactions are associated with upgrade announcements. Through sub sample and the cross-sectional analysis this study gain a deeper understanding of the driving forces behind the characteristics of the observed announcement effects and in general it is argued that variations in announcement effects are driven by various event and issuer specific characteristics and these can be related to the relevance and implication of the information’s as well as degree of market anticipation. Specifically the credit ratings updates driven by changes in profitability and market position are more pricing relevant than those motivated by changes in capital structure and rating events proceeded by official opinions of the likely direction of the credit rating update have less pricing impact. Based on these two dimensions this study identifies several additional aspects of the credit rating process with implications for the impact on equity returns. These explanatory factors provide the foundations for comprehensive analysis of the asymmetric reactions between upgrades and downgrades as well as cross-sectional variations for both rating events.