Non-Linear Effects of Bond Rating Changes
by Philippe Jorion of the University of California, Irvine, and
Abstract: This paper demonstrates the importance of the initial credit rating when assessing the effect of a bond rating change on the company's stock price. First, we provide theoretical support for different price effects as a non-linear function of the initial credit rating, using a structural, Merton type model linking the change in default probability to the change in the stock price. In particular, rating changes should have much greater effects when starting from a lower initial credit rating. This is strongly verified in the empirical data. Accounting for this non-linearity explains in large part the puzzling empirical regularity that stock price effects are associated with downgrades but not upgrades. In addition, it eliminates the investment-grade barrier effect reported in previous studies.
Keywords: credit rating agencies, market reaction, event study, default probability.
Published in: Journal of Fixed Income, Vol. 16, No. 4, (Spring 2007), pp. 45-59.