Credit Ratings and Credit Risk: Is One Measure Enough?

• Departmental Seminar

Date and Location

Tuesday, April 7, 2015, 10:30 AM - 12:00 PM
3001 Plant and Environmental Sciences

Abstract

This paper investigates the information in corporate credit ratings from a positive and normative perspective. If ratings are to be informative indicators of credit risk they must reflect what a risk-averse investor cares about: both raw default probability and systematic risk. We find that ratings are inaccurate measures of raw default probability - they are dominated as predictors of failure by a simple model based on publicly available financial information. However, ratings do contain relevant information since they are related to a measure of exposure to common (and undiversifiable) variation in default probability, exposure that is related to CDS risk premia. Given the multidimensional nature of credit risk, it is not possible for one measure to capture all the relevant information. In consequence, ratings may be prone to misinterpretation.