Credit Ratings and Credit Risk

by Jens Hilscher of the Brandeis University, and
Mungo Wilson of the Oxford University

June 2011

Abstract: This paper investigates the information in corporate credit ratings. We examine the extent to which firms' credit ratings measure raw probability of default as opposed to systematic risk of default, a firm's tendency to default in bad times. We find that credit ratings are dominated as predictors of corporate failure by a simple model based on publicly available financial information ('failure score'), indicating that ratings are poor measures of raw default probability. However, ratings are strongly related to a straight-forward measure of systematic default risk: the sensitivity of firm default probability to its common component ('failure beta'). Furthermore, this systematic risk measure is strongly related to credit default swap risk premia. Our findings can explain otherwise puzzling qualities of ratings.

JEL Classification: G12, G24, G33.

Keywords: credit rating, credit risk, default probability, forecast accuracy, systematic default risk

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