Ratings Arbitrage and Structured Products

by John Hull of University of Toronto, and
Alan White of University of Toronto

Fall 2012

Abstract: This paper examines the criteria used by credit rating agencies when they rate structured products. We assume that some investors use credit ratings as a basis for valuing products. This leads to a necessary condition for a credit ratings criterion to be arbitrage-free. We find that the criterion used by S&P and Fitch does not satisfy the condition and explain that this criterion could have misled investors when subprime mortgages were being securitized.

JEL Classification: G10.

Keywords: Credit rating, Arbitrage, Structured Products, Crisis, Subprime.

Published in: Journal of Derivatives, Vol. 20, No. 1, (Fall 2012), pp. 80-86.

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