Evelina Lazareva Nottingham Trent University

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1 Do rating agencies confirm or surprise the market? Market Efficiency Hypothesis vs Conspiracy Theory Boston October 10, 2015 Nottingham Trent University

2 Overview 1. Literature Review Conspiracy Theory Market Efficiency Hypothesis General Idea 2. Empirical Approach Methodology (event parameter) Specification (CAPM-like model) Four Hypotheses 3. Descriptive statistics By yields By announcements 4. Main Findings 5. Robustness analysis Six different checks 6. Conclusions

3 Market Efficiency Hypothesis Literature Review Conspiracy Theory All the information used in assessing sovereign debts are publicly available Efficient markets price information immediately after news occurs Absence of asymmetric information between the market and CRAs. Sovereign debt ratings are assigned by at least two major CRAs Sovereign debt ratings are unsolicited and assigned free of charge Rainer Bruederle: "I am no fan of conspiracy theories, but [ ] American ratings agencies and fund managers are working against the eurozone." (The Guardian, 2012) There are two superpowers in the world today in my opinion. There's the United States and there's Moody's Bond Rating Service. The United States can destroy you by dropping bombs, and Moody's can destroy you by downgrading your bonds. And believe me, it's not clear sometimes who's more powerful (New York Time,1996) The rating agencies were part of the conspiracy that fed the housing bubble (Stiglitz, 2012)

4 Efficient Market Hypothesis: General Idea The market anticipates announcements Positive Announcements Conspiracy theory: Annoucements surprise the market RETURN Efficient Market Hypothesis RETURN Conspiracy Theory The market anticipates the announcement The market is surprised by the announcement TIME TIME POSITIVE EVENT POSITIVE EVENT

5 Efficient Market Hypothesis: Efficient Market Hypothesis NEGATIVE EVENT General Idea The market anticipates announcements RETURN Negative Announcements Conspiracy theory: Annoucements surprise the market RETURN Conspiracy Theory NEGATIVE EVENT TIME TIME The market anticipates the announcement The market is suprised by the announcement

6 Event study (two-steps) Step 1: Regression on the estimation window Step 2: Prediction on the event window Determination of cumulative abnormal returns by difference Methodology Event-parameter (one-step) Step 1: Regression on both estimation and event windows Determination of cumulative abnormal returns using a dummy variable (estimation window] (event window] (post-event window] 0 T0 T1 T2 T3 Advantages of chosen approach: Simpler, more efficient and flexible, it avoids aggregation problems, it minimizes the loss of information as a result of the two-step approach

7 Empirical specification: CAPM-like model A parsimonious CAPM-like model for bonds derived from the yield curve. Assumption: all bonds are zero coupon bonds Advantages: Easier to use Suitable for an event study Adjustments 1) replacement of the equity returns short-term bond index returns 2) replacement of the market returns long-term bond index returns 3) CAPM CAPM-like Expectation: ² <1, because of the investors preference for liquidity (i.e. the reaction to shocks is larger in the long run than in the short run)

8 Empirical Hypotheses: General Framework HYP1: overall significance of announcements by CRAs RR SSSSSSSSSS ii,tt = α + β RR LLLLLLLL ffffffff ffffffff ii,tt + γ NNNNNN ii,tt + τ PPPPPPii,tt + εii,tt (1) HYP2: impact of negative and positive announcements RR SSSSSSSSSS ii,tt = α + β RR LLLLLLLL ppoooooo ppoooooo ii,tt + γ NNNNNN ii,tt + λnnnnnnii,tt + τppppppii,tt + θppppppii,tt + εii,tt (2) HYP3: impact of announcements in pre- and post-event windows RR SSSSSSSSSS LLLLLLLL ii,tt = α + β RR ii,tt pp pp +γ 11 MMMM_NNNNNN ii,tt + λ11 MMMM_NNNNNN ii,tt + τ11 MMMM_PPPPPP ii,tt + θ11 MMMM_PPPPPP ii,tt +γ 22 SSSS_NNNNNN ii,tt pp + λ 22 SSSS_NNNNNN ii,tt + τ 22 SSSS_PPPPPP ii,tt pp + θ22 SSSS_PPPPPP ii,tt +γ 33 FFFF_NNNNNN ii,tt pp + λ 33 FFFF_NNNNNN ii,tt + τ33 FFFF_PPPPPP ii,tt pp + θ33 FFFF_PPPPPP ii,tt + εii,tt (3) HYP4: efficiency vs conspiracy theory individually for each CRA

9 Empirical Hypotheses: Negative-vs-Positive HYP1: overall significance of announcements by CRAs RR SSSSSSSSSS ii,tt = α + β RR LLLLLLLL ffffffff ffffffff ii,tt + γ NNNNNN ii,tt + τ PPPPPPii,tt + εii,tt (1) HYP2: impact of negative and positive announcements RR SSSSSSSSSS ii,tt = α + β RR LLLLLLLL ppoooooo ppoooooo ii,tt + γ NNNNNN ii,tt + λnnnnnnii,tt + τppppppii,tt + θppppppii,tt + εii,tt (2) HYP3: impact of announcements in pre- and post-event windows RR SSSSSSSSSS LLLLLLLL ii,tt = α + β RR ii,tt pp pp +γ 11 MMMM_NNNNNN ii,tt + λ11 MMMM_NNNNNN ii,tt + τ11 MMMM_PPPPPP ii,tt + θ11 MMMM_PPPPPP ii,tt +γ 22 SSSS_NNNNNN ii,tt pp + λ 22 SSSS_NNNNNN ii,tt + τ 22 SSSS_PPPPPP ii,tt pp + θ22 SSSS_PPPPPP ii,tt +γ 33 FFFF_NNNNNN ii,tt pp + λ 33 FFFF_NNNNNN ii,tt + τ33 FFFF_PPPPPP ii,tt pp + θ33 FFFF_PPPPPP ii,tt + εii,tt (3) HYP4: efficiency vs conspiracy theory individually for each CRA

10 Empirical Hypotheses: Efficiency-vs-Conspiracy HYP1: overall significance of announcements by CRAs RR SSSSSSSSSS ii,tt = α + β RR LLLLLLLL ffffffff ffffffff ii,tt + γ NNNNNN ii,tt + τ PPPPPPii,tt + εii,tt (1) HYP2: impact of negative and positive announcements RR SSSSSSSSSS ii,tt = α + β RR LLLLLLLL ppoooooo ppoooooo ii,tt + γ NNNNNN ii,tt + λnnnnnnii,tt + τppppppii,tt + θppppppii,tt + εii,tt (2) HYP3: impact of announcements in pre- and post-event windows RR SSSSSSSSSS LLLLLLLL ii,tt = α + β RR ii,tt pp pp +γ 11 MMMM_NNNNNN ii,tt + λ11 MMMM_NNNNNN ii,tt + τ11 MMMM_PPPPPP ii,tt + θ11 MMMM_PPPPPP ii,tt +γ 22 SSSS_NNNNNN ii,tt pp + λ 22 SSSS_NNNNNN ii,tt + τ 22 SSSS_PPPPPP ii,tt pp + θ22 SSSS_PPPPPP ii,tt +γ 33 FFFF_NNNNNN ii,tt pp + λ 33 FFFF_NNNNNN ii,tt + τ33 FFFF_PPPPPP ii,tt pp + θ33 FFFF_PPPPPP ii,tt + εii,tt (3) HYP4: efficiency vs conspiracy theory individually for each CRA

11 Empirical Hypotheses: Rating Agencies HYP1: overall significance of announcements by CRAs RR SSSSSSSSSS ii,tt = α + β RR LLLLLLLL ffffffff ffffffff ii,tt + γ NNNNNN ii,tt + τ PPPPPPii,tt + εii,tt (1) HYP2: impact of negative and positive announcements RR SSSSSSSSSS ii,tt = α + β RR LLLLLLLL ppoooooo ppoooooo ii,tt + γ NNNNNN ii,tt + λnnnnnnii,tt + τppppppii,tt + θppppppii,tt + εii,tt (2) HYP3: impact of announcements in pre- and post-event windows RR SSSSSSSSSS LLLLLLLL ii,tt = α + β RR ii,tt pp pp +γ 11 MMMM_NNNNNN ii,tt + λ11 MMMM_NNNNNN ii,tt + τ11 MMMM_PPPPPP ii,tt + θ11 MMMM_PPPPPP ii,tt +γ 22 SSSS_NNNNNN ii,tt pp + λ 22 SSSS_NNNNNN ii,tt + τ 22 SSSS_PPPPPP ii,tt pp + θ22 SSSS_PPPPPP ii,tt +γ 33 FFFF_NNNNNN ii,tt pp + λ 33 FFFF_NNNNNN ii,tt + τ33 FFFF_PPPPPP ii,tt pp + θ33 FFFF_PPPPPP ii,tt + εii,tt (3) HYP4: efficiency vs conspiracy theory individually for each CRA

12 Descriptive Statistics: Announcements Focus: CRA s announcements on sovereign debt Period: , but the panel is strongly unbalanced Sample: 43 countries Expectation: the post-announcement adjustment predicted by the conspiracy theory

13 Descriptive Statistics: Yields Group OECD EZ OECD Extra- EZ No OECD Country Y ST Y LT Mean St.Dev. Mean St.Dev. AUSTRIA FRANCE GERMANY GREECE ITALY SPAIN Total OECD EZ JAPAN TURKEY UNITED KINGDOM UNITED STATES Total OECD Extra-EZ ARGENTINA BRAZIL CHINA INDIA SOUTH AFRICA Total No OECD Total

14 Main Empirical Findings Dependent R SHORT R SHORT R SHORT R SHORT VARIABLES OLS+CL t OLS+CL t RE i +CL t LSDV i +DK i+t R LONG 0.636*** 0.636*** 0.636*** 0.634*** NEG full *** POS full * NEG pre ** ** ** NEG post *** *** *** POS pre # # * POS post # # Constant *** *** *** * Observations Adj-R Prob > F All Agencies Prob > F Market Eff. Prob > F Conspiracy Prob > F NEG Prob > F POS Prob > F

15 Market Efficiency vs Conspiracy Theory The post-event reaction is approximatively: 2 times larger than the pre-event reaction for positive announcements (green) 3 times larger than the pre-event reaction for negative announcements (red)

16 Main Empirical Findings Dependent R SHORT R SHORT R SHORT VARIABLES Moody s S&P Fitch R LONG 0.636*** 0.636*** 0.636*** NEG pre * *** NEG post *** ** *** POS pre POS post * ** Constant ** ** ** Observations Adj-R Prob > F All Agencies Prob > F Market Eff. Prob > F Conspiracy Prob > F NEG Prob > F POS Prob > F

17 Robustness Analysis To check the robustness of our results, we run different econometric exercises: (1) by subsample (country group) (2) over the shorter recent period (no crisis) (3) using medium-term bond index as a dependent variable or independent variable (4) applying different window sizes and including the event day in the post-event window (5) adding the stock market daily rate of return S i as a control (6) combining previous points in different ways

18 Conclusions Main results are: The bond market is surprised by CRAs announcement, as predicted by the conspiracy theory The empirical evidence increased recently, in particular in the EZ The market efficiency hypothesis holds partially for no OECD countries Contribution to the exiting literature on CRAs: Development of a parsimonious simple CAPM-like model for bonds Develop a structured framework for testing hypotheses on CRAs announcements Evidence in favour of the conspiracy theory Policy implication: reduce the power attributed to ratings in accounting standards, and not to assign an excessively influential role to credit ratings agencies.

Corporate Governance, and the Returns on Investment

Corporate Governance, and the Returns on Investment Klaus Gugler, Dennis C. Mueller and B. Burcin Yurtoglu University of Vienna, Department of Economics BWZ, Bruennerstr. 72, A-1210, Vienna 1 Considerable