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Are Credit Ratings Bias-free?

Recently I got a chance to interact with a group of researchers, and while chitchatting I came to know some (un-)usual stuff about the intermediary called credit rating agency. A credit rating agency is basically an entity that assigns credit ratings for issuers of certain types of debt obligations as well as the debt instruments themselves. In some cases, the debt-servicing entity for the underlying debt is also assigned ratings. Credit ratings can be any of AAA, BBB, BB, BB(-) and so on depending on various underlying factors. Investors, issuers, investment banks, brokers, dealers, and governments use credit ratings for their specific purposes of assessing risk of various types such as credit risk, liquidity risk, etc.

Well, my purpose of discussion in this post is not about credit rating agencies or its functioning, rather I wanted to discuss some of the behavioural issues associated with the credit ratings and its impact of stock prices/valuation.

Although securities markets are said to be informationally efficient, it means that any new piece of information is absorbed into the security’s prices quickly, according to the efficient market hypothesis (EMH). And securities are given credit ratings on the basis of fundamentals, i.e., the information that is already available in public domain. Then, how come a credit rating for any security, when released, has a sizable effect on market? Doesn’t there involve some behavioural phenomena?

We all know that this is not a generalized case where all the information reflected in credit ratings are public. Of course, there are cases when the market did not have all the information that are exclusively available to a credit rating agency.  Then, it should ideally have significant impact on markets when credit rating decisions are released.

It has been observed that the impact on the markets can vary significantly from time to time as may not be consistent. Such news can be used by traders to test either the upside or downside of the markets. Once traders can successfully drive the market to one side, herding usually follows.

One of the experts was of opinion that most of the information being in public domain, yet the rating has an advantage as they are subject to some major concerns as follows:

(a)    Credit rating agency decisions are structured form of study different from the information available in public domain which might  be difficult to analyze for any individual;

(b)   Such reports include specific parameters as applicable for the respective industry;

(c)    Credit rating agency’s decisions involve detailed analysis of historical information, which may be again beyond scope for any investor;

(d)   Present and future courses and directions of the concerned organization are discussed in details;

(e)    Business risk, beta and other parameters including peer comparison not only with the benchmarked company(-ies), but also with others in the industry, are analyzed;

(f)    Last but not the least, management skills and profitability are emphasized is credit rating reports.

It is true that there is subjectivity involved in credit rating agencies; hence, these reports are not completely free from psychological biases. Behavioural finance has become an integral part of finance and financial decisions. Take a note of it!!

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