Abstract A credit rating compresses a large variety of information that needs to be known about the creditworthiness of the issuer of bonds and certain other financial instruments

Abstract
A credit rating compresses a large variety of information that needs to be known about the
creditworthiness of the issuer of bonds and certain other financial instruments. Credit rating
agencies provide the borrower’s ability to repay the debt obligation (creditworthiness)
information to investors thereby serving as information intermediary between lenders and
borrowers.

The information contained in the credit rating is debated worldwide. One school of thought
believes that change in credit rating does not carry any new information to the market. The other
school of people believes that change in credit ratings do carry valuable information which is
observed in the abnormal returns of the stock prices.

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In general, there is considerable evidence that downgraded rating announcements
provide new information seen through statistically significant abnormal returns, while the
upgraded rating announcements do not provide any new information and is already embedded in
the stock prices.

In this paper, we examine whether rating change announcements signal new information
to Indian stock market in general and banking sector in particular using event study
methodologyKey Words: Credit rating changes, Abnormal Returns, Event Study
1. INTRODUCTION
The countries have opened up ; the world has become small. Localization is replaced by
globalization, the horizons of markets are expanding. Investments are crossing the boundaries,
Collaboration at international level has become common and the very business thinking is
undergoing metamorphosis. The Growth of any country to a greater extent depends upon the
efficient ; vibrant economic system. The financial system which facilitates the transformation of
funds from Surplus spending units to Deficit spending units started growing in geometric
progression from 1970?s (The era of LPG) at the global level and from 1990?s onwards at the
national level. All the four major components of Financial System – Financial Institutions,
Financial Instruments, Financial Markets, and Financial Services – have been growing rapidly.

Financial institutions create Financial Services as their output for consumers, they are
motivated to serve needs in society and earn profit just as the manufacturing firms that produce
tangible goods. Manufacturing firms use physical assets to produce tangible products, where as
financial firms use financial instruments to offer their services. Thus Financial Instruments
represent paper wealth that substitutes for real wealth. To cater to the needs of diverse categories
of investors, various tailor made financial instruments were created ; introduced. Increasing
varieties of instruments and the growth of financial market created not only the opportunities for
the investors but also complexities in the market, the reputation of the issuer Co. is no longer a
guarantee to the quality of Financial instrument which the Co. issues. Hence, general caution to
the customers. Caveat emptor (buyer beware), is also applicable to financial market investors.

To demystify the complexity of financial instruments in the financial market, to facilitate
the investors to take informed investment decisions and to enable the issuer companies /
Institutions to mobilize the required funds. Various credit rating agencies emerged across the
globe.

Credit Rating
A credit rating compresses a large variety of information that needs to be known about
the creditworthiness of the issuer of bonds and certain other financial instruments. Credit rating
agencies (CRAs) provide the borrower?s ability to repay the debt obligation (credit worthiness)
information to investors thereby serving as information intermediary between lenders and
borrowers. The CRAs thus contribute to solving principal agent problems by helping lenders
“pierce the fog of asymmetric information that surrounds lending relationships and help
borrowers emerge from that same fog” (White, 2001). While, on the other hand, CRAs are
heavily criticized for not providing proactive, reliable and credible information in the form of
ratings during the Asian Crisis, Subprime crisis, Satyam, Lehman brothers etc.

The information contained in the credit rating is debated worldwide. Studies by Weinstein
(1977), Wakeman (1978, 1990), Zaima and McCarthy (1988), Pinches and Singleton (1978);
Creighton, Gower and Richards (2007) ; Mohindroo (2008) shows that CRAs have no special
information, while they summarize publicly available information and rating change
announcements convey no new information to the market. On the other hand, studies by Ingram
et al., (1983), Hand, Holthausen, ; Leftwich, (1992), Dichev and Piotroski (2001), observed
abnormal returns in stock prices owing to rating change announcements, and concluded that
CRAs deliver valuable information to the market. Also, the rating agencies declare that they
receive inside information and rating is a means of communicating significant facets of such
information to the stock holders, without exposing detrimental details to the opponents (Rao ;
Sreejith, 2013). In general, there is considerable evidence that downgraded rating announcements
provide new information seen through statistically significant abnormal returns, while the
upgraded rating announcements do not provide any new information and is already embedded in
the stock prices.

Scope
The study focuses on Indian Credit rating agencies (CRISIL, CARE, ICRA, FITCH,
BRICKWORKS and SMERA) and it is restricted to study the bond rating announcements of
banking sector.

2. LITERATURE REVIEW
2.1 Literature on the Impact of credit rating changes on stock prices in Indian Context
Rao and Sreejith (2013) examined the impact of credit ratings by all five credit rating agencies
(CRISIL, ICRA, CARE, Fitch and Brickwork) on equity returns in India during the period 1st
January, 1999 to 31st March, 2013. The authors employ event study methodology. Abnormal
returns were computed using Mean Adjusted Model, Market Adjusted Model and
Conditional Risk Adjusted Model (Standard Market Model) and yielded similar results. T test
is used to test the significance of the abnormal returns. The study revealed that downgrades had a
considerable negative impact and upgrades had negligible positive impact.

Chandrashekar and Mallikarjunappa (2013) studies the impact of bond rating on Indian stock
market for the period 1998 to 2005. The results show statistically insignificant abnormal return
associated with the bond down grades, small but insignificant positive abnormal returns for
upgrades and concludes that bond upgrades and downgrades do not convey any important
information to the market.

Chandrashekar and Mallikarjunappa (2013) examines the reaction of stock returns to the
initial bond rating and concludes that returns associated with the rating events are insignificant,
unlike the prior studies which showed stock prices react negatively to the announcement of
downgrades of bond ratings, while weaker positive excess bond and stock returns are found for
upgrades.

Lal and Mitra (2011) examines the effects of rating changes announcements on share prices in
India using event study methodology during the time period 1 April 2002 to 31 March 2008. The
study found that rating upgrade or downgrade does not come as a surprise to the investors so as
to impact the pricing significantly. But at the same time investors react moderately for upgrades
and downgrades are received more negatively by investors with significant negative abnormal
returns.

Rao and Ramachandra (2004) evaluate the response of stock prices and volumes to bond rating
changes in Indian capital market. They found that stock price incorporates the factors that lead to
rating revisions. They also report that upgrades are received cautiously by the investors with no
significant abnormal returns where as downgrades are perceived as bad news by investors with
significant negative abnormal returns.

2.2 Literature on the impact of credit rating changes on stock prices in Global context
Hui, Nuttawat and Puspakaran (2004) studied the effects of Credit Rating Announcements on
Shares in the Swedish Stock Market for the period February, 1992 to February, 2003. The
authors employ event study methodology using EVENTUS package and cumulative average
abnormal returns (CAAR) were computed based on a GARCH (1,1) model. The study showed
that there is no significant share price reaction for rating assignments, positive outlooks and
affirmations announcements following credit rating announcements in both the long-term and
short-term. However, there is significantly positive (negative) market reaction to the upgrade
(downgrade) announcements.

Taib, Iorio, Hallahan and Bissoondoyal-Bheenick studies the impact of corporate bond rating
announcements on stock prices of companies in UK and Australia. The authors use daily data
from 1st Jan 1997 to 31st Dec 2006 and find a significant effect to downgrades both in the UK
and Australia markets. Also, finds evidence that stock price reaction during upgrade
announcements is weak.

Taib, Iorio, Hallahan and Bissoondoyal-Bheenick examines the impact of corporate bond rating
revisions on UK stock market during the period January 1997 to December 2006 and also
compares alternative techniques for estimating abnormal returns. The authors employ four returngenerating models (the conventional market model, the quadratic market model, the downside
market model and higher order downside market model) to analyze the stock price impact. The
results show that there is an announcement effect for bond downgrades, but not upgrades.

Despite differences in approach, all four return generating models produce similar results when
used in the event studies.

Barron, M.J., Clare, A.D, and Thomas, S.H. (1997) examines the impact of new credit ratings,
credit rating changes and Credit Watch announcements during the period 1984 to 1992 on UK
common stock returns. We find significant negative excess returns around the date of a
downgrade and positive returns close to the date of a positive CreditWatch announcement. New
ratings, whether short or long-term, have no significant impact on returns.

Creighton, Gower and Richards (2007) study the response of bond yield spreads and equity
prices to credit rating changes in the Australian financial markets between January 1990 and July
2003. The empirical evidence reveals that bond spreads appear to widen in response to ratings
downgrades and contract with upgrades and equity prices tend to fall on days of downgrades and
rise on days of upgrades.

Choy, E. Y. W, Gray, S. F, and Ragunathan, V. (2006) examines the impact of rating changes
done by two agencies Moody?s and S;P on the Australian stock market between 1989 and 2003.

The results indicated a significant and negative impact for downgrades that are anticipated and
unanticipated, and an insignificant impact for upgrades.

Abner and Andrea investigates the Latin American stock price reaction for a rating change or
Credit Watch announcement. The authors employ event study methodology to analyze stock
market reaction to rating change news in four major Latin American economies: Argentina,
Brazil, Chile and Mexico. The results show similar results to those previously observed in the
literature, where in the impact is quite significant for rating downgrades but less relevant for
rating upgrades and Credit Watches. Cross section regressions indicate absolute change in the
number of notches for downgrades is a significant variable that best explains the impact rating
changes announcements have on stock prices in these countries.

Jorion and Zhang (2007) examined the impact of rating changes on senior unsecured corporate
bonds of US issued during 1996 Jan to 2002 May. The results support the previous findings that
the downgrades have a greater impact than upgrades. Their results also showed that the
downgrades of speculative grade bonds increase the default probability and cost of capital to
company, while downgrades on investment grade bonds create ripple like fluctuations in default
probability and cost of capital. Therefore downgrades in speculative issues more heavily impact
price changes than downgrades in investment grade issues. They also find a significant average
CAR for upgrades of speculative grade issues.The review highlights that there is limited studies in Indian context and there is no clear
evidence pertaining to the impact of rating change announcements of bank?s stock prices. Based
on the above context, the following objectives, hypothesis is developed.

3. OBJECTIVES AND HYPOTHESIS OF THE STUDY
1. To study the impact of credit rating changes (Upgrades and Downgrades) on the bank?sstock prices
2. To investigate whether there are any significant abnormal returns (whether positive or negative)
related to the credit rating change announcements.

HYPOTHESIS
H0: Credit rating announcements has no impact on bank?s stock prices
Credit rating announcements has an impact on bank?s stock prices
H0: There is no significant abnormal return associated with credit rating announcements
CAARt = 0
There is significant abnormal return associated with credit rating announcements
CAARt ? 0
4. SAMPLE AND DATA
The rating changes by CRISIL, CARE, ICRA, FITCH, BRICKWORKS, SMERA are extracted from
2007 to 2015 April using Ace equity database. Our initial sample consisted of 28 events (17 upgrades and
11 downgrades). The sample was checked for other major events (such as merger or acquisition,
divestment, buyback of shares, stock split etc) during the period, if found, the event is said to be
contaminated. After applying the above criteria, the final sample consisted of 26 events (15 upgrades and
11 downgrades). Daily stock prices are taken from BSE historical prices and Yahoo finance portals for
each of the event from day – 280 to + 30. The Benchmark Index considered for the study is BSE
SENSEX.5. METHODOLOGY
The methodology used here is event study. The basic idea is to find the abnormal return attributable
to the event being studied by adjusting for the return that stems from the price fluctuation of the market as
a whole. (Ronald and Bernard 1995).5.1 Event Window
The literature about market reaction to rating announcement does not have a consensus in the
event window definition. Dichev and Piotroski (2001) check different event windows: 0 (date of the
announcement) to 3 months, to 6 months, to 1 year, to 2 years and to 3 years after the announcement.

Jorion and Zhang (2007) checked the event window of 1 year before to 1 year after the announcement. Ee(2008) tested different windows: 1 day before to 1 day after, 3 days before to 3 days after, 50 days before
to 26 days before, 25 days before to one day before. (Abner de Pinho ; Andrea Maria, 2013). However,
the choice of the window is arbitrary and “should not be too long, because it would be encompassing
other events, generating biases, nor too small, because it would be failing to fully capture the abnormality
in prices” (Camargos ; Barbosa, 2003).

Similarly, Brown and Warner (1985) uses eleven day event period (– 5 to + 5) to analyse daily stock
returns. Wansley. J. w., Lane. W. R and Yang H. C., (1987) and Dodd Peter (1980) used – 50 to +50
event period to examine the effect of merger announcement on stock return. Chandrashekhar R and
Mallikarjunappa T (2013) use 61 day event period (-30 to + 30), Vaithanomsat (2001) uses -10 to + 10,
Sehgal (2013) uses -20 to + 20, Goh and Ederington(1999) uses -60 to + 60, Lal and Mitra (2011) uses –
30 days to + 30 days.In this study, we have used 61 day event window, 30 days before (-30) and thirty days after (+30) the date
of rating change announcement (0).

5.2 Calculating expected returns and Abnormal returns
Market adjusted model developed and suggested by Sharpe (1963) is used to calculate the
expected return. The prior studies use extensively the market model to determine the expected return on
specific asset, given the return on market and the two parameters of the market model (alpha and beta of
the security). Market model is based on the fact that the most important factor affecting stock returns is
market factor and it is captured in the market model in the form of the parameters.

The market model for calculating expected return is given by the following regression equation:
E (Rjt) = ?j + ?j RmWhere,
E (Rjt) is the expected return on security j,
?j is intercept. (Mean return over the period not explained by the market).

Rm is the expected market return,
?j is the slope of the regression
Daily returns/actual returns are calculated as below:-
Rjt = ln (Pjt/ Pij-1)
Where
Rjt is the daily return on security „j? on day „t?.

Pit is the daily adjusted price of the security „i? at the end of period„t?.

Pit-1 is the daily adjusted price of the security „i? at the end of period„t-1?.

Rmt = ln(I.t/ I t-1)
Where,
Rmt is the daily return on market index on day „t?. I.t and I t-1 is the closing index value on day „t? and „t-1?
, respectively.The abnormal return is the difference between the actual return on day t and the expected return i.e.,ARjt = Rjt – E(Rjt)
Where,
ARjt is the abnormal return
Abnormal returns represents that part of the return which is not predicted and is, therefore, an estimate of
the change in firms share price on that day which is caused by the announcement of credit rating.

Abnormal returns are averaged across firms to produce AARt for day „t? using the following formula,
Where, N is the number of firms in the sample. Finally we calculate the cumulative average abnormal
return (CAAR) for the event period. The cumulative average abnormal return represents the average total
effect of the event across all firms. Where,
5.3 Parametric Significance test
Parametric t-statistic is used to examine the statistical significance of AARs and CAARs. It is tested at 5
percent level of significance and appropriate degree of freedom. It is given by
5.3.1 The t Test Statistic for AARs
The statistic is given by
t = AARt/ ?AARt (Standard error of AAR)
Where AAR =average abnormal return, ?AARt = standard error of average abnormal return.

The standard error is calculated by using following formula.

SE = ?/?n
Where, S.E = standard error, ? = standard deviation, n = number of observation.

5.3.2 The t Test Statistic for CAARs
The statistic is given by
t = CAARt/ ?CAARt (Standard error of CAAR)
SE = ?/?n
Where, S.E = standard error, ? = standard deviation, n = number of observation
Chart1: Average Abnormal Returns of event window for upgrades
AARs are negative for 19 days and positive for 11 days before the Announcement of the event
and negative for 15 days after the announcement and positive for 16 days after the Announcement of the
event. During the whole event period for upgrades, AARs are negative for 34 days and positive for 27
days. AARs are significant for only 1 day before the event in the event window. This shows that the stock
movement persists even after the change in credit rating signaling that credit rating upgrade has not
increased the bank?s stock price.

.
AARs are negative for 14 days and positive for 16 days before the Announcement of the event
and negative for 8 days after the announcement and positive for 23 days after the Announcement of the
event. During the whole event period for downgrades, AARs are negative for 22 days and positive for 39
days. AARs are positive for majority of the days in the event window and statistically insignificant for
majority of the days (56 of 61 days). Hence, we accept the null hypothesis which states that change in
credit rating has no impact on bank?s stock prices. Also, abnormal returns are found which are statistically
insignificant.

7. CONCLUSION
The study examines the impact of bond rating changes on bank?s stock prices. Analysis reveals
that AARs are negative and statistically insignificant for majority of the days in case of rating
upgrades and AARs are positive and statistically insignificant for majority of the days for rating
downgrade announcements. The study also reveals that credit rating announcements have no
special information, while they summarize publicly available information and rating change
BITM-DMS. A Conference on: The Future of Management. 29 th Aug, 2015
www.shreeprakashan.com [email protected],Vol-IV,Issue –VIII, Aug,2015. Page 269
announcements convey no new surprises to the market and hence, we conclude that there are no
significant abnormal returns associated with rating change announcements. However, our results
cannot be generalized as it based on a small sample

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