The Information Content of Initial Firm Rating Announcements

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The Information Content of Initial Firm Rating
Announcements

• Paper Presenter Chih-Hsiang Chang
• Department of Finance
• National University of Kaohsiung

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INTRODUCTION

• Information asymmetry exists in markets where
  sellers know more about product quality than
  buyers.
• The question of whether rating announcements
  convey information previously unknown to
  investors has long attracted research interest.
• While rating announcements can be for either
  initial ratings or rating changes, the majority
  of past studies have concentrated on the
  announcement effect of the latter.

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INTRODUCTION (Cont.)

• Our study differs from previous research in at
  least two important aspects.
• We examine the market reaction to announcements
  of initial firm ratings, rather than debt
  ratings.
• This study establishes a theoretical framework to
  analyze the information content of initial
  ratings and should therefore yield more fruitful
  and plausible findings.

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INFORMATION ASYMMETRY AND SEQUENTIAL SIGNALING

• How would the market respond to initial rating
  announcements?
• A high initial rating can induce negative
  reactions from the market just as likely as a low
  rating to draw positive responses.
• Potential buyers will then compare it against the
  average quality and adjust its market value
  accordingly.

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INFORMATION ASYMMETRY AND SEQUENTIAL SIGNALING
(Cont.)

• If stock price is lower than that if true
  quality is known to the market, we say its stock
  price is suffering a penalty premium due to
  information asymmetry.
• Firms have enough incentive to signal next,
  since its penalty premium will now be greater
  than the cost of signaling.
• sequential signal process

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INFORMATION ASYMMETRY AND SEQUENTIAL SIGNALING
(Cont.)

• When credit rating as a cost-effective signaling
  alternative becomes available, it is those
  marginal firms that will reap the most signaling
  benefit.
• Signaling through initial firm ratings thus can
  be more beneficial for smaller firms.

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METHODOLOGY AND DATA

• Abnormal Returns and Initial Rating Announcements
  
• The standard market model
• The GARCH(1,1) model
• The three-factor model

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METHODOLOGY AND DATA (Cont.)
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METHODOLOGY AND DATA (Cont.)

• Changes in Return Volatility Following Initial
  Rating Announcements

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METHODOLOGY AND DATA (Cont.)

• Empirical Data
• A total of 118 firms (1997-2004)
• Our final sample thus consists of 74 companies
  that have received their first ever credit
  ratings.
• Trading data are collected from Taiwan Economic
  Journal (TEJ) database and Taiwan Economic
  Statistical Databank (TESD).

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EMPIRICAL RESULTS
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EMPIRICAL RESULTS (Cont.)

• This finding lends support to the proposition
  that the information content of initial firm
  rating announcements is more significant for
  smaller firms.
• We observe that the effect of initial rating
  announcement is fully reflected soon after the
  announcement day, suggesting that the stock price
  react rapidly to the information conveyed through
  initial ratings.

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EMPIRICAL RESULTS (Cont.)
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EMPIRICAL RESULTS (Cont.)

• The positive stock price response to firms that
  receive low initial rating.
• Our findings should send a clear message to these
  firms that signaling through initial rating may
  be a sensible choice.

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EMPIRICAL RESULTS (Cont.)
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EMPIRICAL RESULTS (Cont.)

• Initial rating announcements carry information
  value for smaller and lower quality firms in the
  market, but not for high quality ones.
• Initial ratings help reduce information asymmetry
  and induce the positive market response as
  evidenced by either higher stock prices or lower
  return volatility.

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SUMMARY AND CONCLUSIONS

• Initial rating announcements help to reduce the
  penalty premium that has been imposed on their
  stock prices due to information asymmetry.
• The findings of this study have important
  implications for many small and low quality firms
  in the market.