Credit Rating Impact on Stock Prices -A Study for India

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All the credit rating announcement data from year 2008 to 2012 is analysed to draw conclusions about the correlation between CRA and stock prices.
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  Effect of Credit Rating Change Announcement On Shares in Indian Stock Markets Ved Prakash Gupta   and Anu Khandwal   Department of Mathematics and Scientific Computing IIT Kanpur, Kanpur, Uttar Pradesh-208016, India Abstract Many researchers around the world have explored about the informational value of Credit Rating Announcements. Earlier studies include research on US, UK, Swedish, New Zealand, Australian and Turkey Markets. Through this paper we intend to show effect of credit rating announcement on companies listed with National Stock Exchange of India (NSE). Large market such as US and UK show little change to negative news and negligible change to positive news while a small market such as New Zealand market show significant reaction to both type of news. In India, results lie somewhere in middle with small and positive reaction to new assignment, small but negative reaction to upgrades, significant and negative reaction to downgrades and negative outlook, while positive reaction was observed for positive placements and finally affirmations had negative impact. These evidences suggest that Credit Rating agencies act as substitute information providers for firms. A separate analysis has also been done for getting results based on market capitalisation and industrial sector. Introduction The informational value of Credit Rating Agency is a controversial issue. This paper aims to analyse the reaction of Indian stock market to credit rating announcement. Many researchers have tried to answer this question by different methods but results are not the same. Many have argued the difference in credit rating reaction to small and large market. Some suggested that it may be due to liquidity factor (James and Edmister 1983) or informational content (Barry and Brown in 1984). Some difference may also be seen because of neglecting small market (Arbel and Strebel 1983). Credit rating agency may affect small market more than large market as they are neglected in comparison to larger one. Let us come back to our question whether credit rating announcement affect stock market or not. Many researchers found no effect of credit rating on stock prices (Weinstein 1977; Pinches and Singleton 1978).Many of them have also suggested that credit rating agency is not valuable for investors and only provided information relevant to the public (Kalpan and Urwitz 1979) and (Wakeman 1981) .Others argued that stock market reacted significantly to the information provided by credit rating announcement. All these findings are generally for large market US, UK and Australia.  The objective of this paper is to show the impact of credit rating announcements on share market for firms in relatively small (See Table 1) but growing market of India. Elayan et al (2003) studied small market reaction i.e. New Zealand market. He found that there was significant reaction for rating upgrades and no significant reaction for affirmations (class for which there is no rating change). The reason in that case was neglecting small markets which were overcome by the information that CRAs provided and invited attention of investors. Some features are very special with Indian Stock markets. NSE is bigger than New Zealand market and almost same as of Australian market but much more liquid.Indian markets are not as transparent as its counterparts and thus CRAs can play an important role. Diamond and Verrechia (1991) shown that in such markets reduction in information asymmetry can attract investment. On the whole, Indian economy has gone down during last 4 years which is clearly represented in the number of downgrades. Same number of companies was affirmed and only a few companies were upgraded (See table 2). Different sectors of the economy have responded very differently to credit rating actions and similar distinctions were seen in the reaction of companies based on their market capitalisation. Companies which underwent a downgrade twice or more in last 5 years have more negative reaction compared to total downgrades. The immediate effect of rating action was negligible but significant effect is observed in 4 to 6 month time. Almost all the companies had negative movement in this three year time period which indicates towards worsening Indian economy. In our paper we found no abnormal return during t-1 to t+1, where t is announcement date. We have also found that after 2 to 6 months the excess returns of stocks are significantly different from zero. This implies that credit rating agency may not be valuable just after the announcement but the information gets incorporated in stock prices after some time. Only a few companies which had rating announcement in 2009-2013 time period were listed with American Depository Receipt (ADR), hence a separate analysis was avoided for that because of lack of data. The rest of the paper includes the following topics: Topic 2- Review of the literature Topic 3- Empirical Findings regarding Credit Rating Topic 4-Hypothesis Topic 5- Data Description and Method of Analysis Topic 6- Empirical Results  Review of Literature Theoretical Aspects of Credit Rating Announcements Ratings provided by CRAs are a measure of the long-term fundamental credit strength of companies, i.e. their long-term ability and willingness to meet their debt servicing obligations. More specifically, ratings apply either to the general creditworthiness of an obligor or to its obligations with respect to a particular debt security (senior and subordinated bonds, either secured or unsecured, collateralised debt structures, etc.) or other specific financial obligations. (Financial Stability Review, No. 4, June 2004) Stover (1999) notes that credit ratings implicitly provide certification associated in the debt market. He cites research by Wakeman (1981), Hsueh and Kidwell (1988), and Thompson and Vaz (1990) discussing the rating agencies’ function of providing estimates of firm credit quality. Wakeman(1991) argues that if CRAs use only public information to decide credit worthiness of a firm than that rating provide no extra information to investors. Kuhner (2001) views credit rating agencies as information intermediaries that help to overcome information asymmetries. He concluded that during periods of systematic risk, credit rating agencies do have some ability to distinguish between categories of fundamental credit risk. He argues that rating assignment do not provide any information that influences decision made by investors during normal time period. In the study of Swedish share market which has a size similar to New Zealand market but twenty six time share, it was found that due to higher liquidity there is more symmetry in information and has CRAs have little role to play. The effect of rating actions is visible in long term period. (The Effects of Credit Rating Announcements on Shares in the Swedish Stock Market,Hui Li et.al.) Data Description and Method of Analysis Data Description The events that were included for analysis were rating assignment, outlooks and ratings actions. The associated time period was from January 2010 to May 2013. A list of all credit rating action was obtained from CRISIL (Credit Rating Information Services of India Limited). Companies’ historical share prices were obtained from Bloomberg Database. Out of initial data, a final sample was considered on the following basis: 1.   Companies to be considered should be listed with National Stock Exchange of India (NSE). 2.   Daily and weekly return data must be available for all those companies for a period of 365 days before the rating announcement and 365 days after the announcement. 3.   No other announcement was made during the t-1 to t+1 time period for any company which could have affected company’s stock performance. Following these restrictions we have a final sample of 212 rating announcements during the study period. In table 2 we have summary of rating actions by year. The classification depicted in table categorized 6 rating announcements. Assignment is an event when credit rating is for the first time assigned. Upgrade is an event when firm's credit rating is upgraded. Downgrade is an event when firm's credit rating is downgraded. The  Outlook provides information to investors on the potential evolution of a rating, hence it increases the precision of the rating. Therefore, Positive outlook is an event when there is prediction that firm's rating may b raised. Negative outlook is an event when firm's credit rating have negative outlook. At last, Affirmation is an event for which there is no change in rating. There are 56(26.42%) assignments forming the largest section. There are 49(23.11%) and 21(9.91%) of downgrade and upgrade respectively. Of all rating actions, there are 25(11.79%) and 11(5.19%) of positive outlook and negative outlook respectively. Second largest section contains 50(23.58%) of affirmed ratings. Indian market is not a very transparent one (I am looking for some document to support this claim) and thus the role of credit rating agencies become important. CRAs come handy in decreasing the information gap between firms and investors and hence are needed as suggested by Wakeman (1981). Development of hypothesis So any new assignment will attract attention and capital from investors which bring us to our first hypothesis: Hypothesis 1 : A new assignment of long term credit rating will show positive and significant impact on firm’s stock return. Earlier studies about US market shown that market does not respond to positive placements and only negative placements are associated with negative and significant reaction. However in a small market like India, which is 16 times smaller than US market, there is a possibility that both positive and negative placements will have significant reaction which brings us to our second hypothesis: Hypothesis 2 : A credit watch placement associated with positive (negative) implication will have significant positive (negative) share market reaction. Large markets such as US and UK do not show significant reaction to upgrade and positive placement, but for India the possibility is high that both upgrades (downgrades) will have significant positive (negative) reaction on Indian share market. Taking this as the reasoning of our hypothesis, we state the third hypothesis: Hypothesis 3:  It is expected that downgrade (upgrade) will be associated with significant negative (positive) excess returns. Hypothesis 4 : Affirmations are not expected to generate any significant movement in share returns as in other markets both small and large. Methodology Classification of Rating Announcement    If any company was not assigned any ranking in 6 years then the new action was considered an assignment. For example, company A was given a rating X in year 2002 and then a rating Y in year 2010 or 2009, then since the time period between two ratings was more than 6
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