The Impact of Credit Rating Change on Stock Return: A Study

This research paper investigates the impact of credit rating changes on stock returns within the UK market, addressing the influence of credit rating agencies on financial decisions. The study aims to determine if changes in credit ratings provide new information, significantly impact stock returns, and affect stock valuation. The paper includes a comprehensive literature review discussing the relationship between stock prices and credit ratings, market anticipation, and the efficient market hypothesis. The methodology section outlines the approach for analyzing specific UK industries and their stock prices. Ethical considerations are also addressed. The research explores the role of credit rating agencies, the informational value of rating announcements, and the potential for investors to exploit predictable rating changes. The literature review covers event study methodology and discusses the responses of bond and equity markets to credit rating upgrades and downgrades. The paper also touches upon the efficient market hypothesis and its relevance in modern financial theory.

Running head: THE IMPACT OF CHANGE IN CREDIT RETURN ON STOCK RETURN
The impact of change in credit rating on stock return
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THE IMPACT OF CHANGE IN CREDIT RETURN ON STOCK RETURN
Table of Contents
Introduction:...............................................................................................................................3
Research objectives:...................................................................................................................3
Research questions:....................................................................................................................3
Literature review:.......................................................................................................................3
Methodology:.............................................................................................................................3
Ethical considerations:...............................................................................................................3
Expected outcome:.....................................................................................................................3

THE IMPACT OF CHANGE IN CREDIT RETURN ON STOCK RETURN
Introduction:
The relationship between stock return and credit risk has been investigated by several
researchers and the financial market and the decision of investors is influenced to a
considerable degree because of the credit rating agencies. Credit ratings are the opinion that
is published by the credit rating agencies about the credit rail associated with the particular
stick. Opinions are expressed by them about the willingness and ability of the issuer so as to
meet the financial obligations according to the obligation terms. Investors, issuers and
investigators views that the good credit rating is important as it help in raising the cost of debt
that are used for raising the debt of company (Alsakka et al. 2015). Agency uses a unique
letter based score indicates the financial stability of the user and whether there is high or low
risk associated with the debt. There are three big credit rating agencies that dominate the
credit rating industry which comprised of Standard and Poor, Moody Inventors services and
Fitch group. The structured financial transactions make use of ratings such as mortgage
backed securities, asset backed securities and collateralized obligation of debt. The price of
stock is influenced by many factors such as economic factors, factors that are company
specific, demand and supply of stock. Furthermore, it is suggested by empirical evidence that
higher return is experienced by low credit risk firms compared to higher credit risk firms.
Researchers have been bemused by such observation as it contradicts that higher is associated
with higher return, which is the founding principle in finance (Barakat et al. 2018).
The current paper investigates the changes in credit rating agencies and the impact
that it has on the stock price by conducting the analysis of specific industries of UK and the
related stock price. Following the introduction, the current research paper is organized in
terms of other section that wrap up the literature that deals with analysis of the relationship
between stock price and rating of credit agencies. Research methodology that would be

THE IMPACT OF CHANGE IN CREDIT RETURN ON STOCK RETURN
employed in conducting the analysis is explained in the next section along with the ethical
factor that should be taken into account while conducting the research.
Research objectives:
The objective of research paper is to determine the impact of credit rating changes on
the equity stock. In addition to this, it is also required to ascertain that whether the firm or
industry is significant in determining the return on equity in response to change in credit
rating. Furthermore, it is required to ascertain whether the return on equity in response to
change in equity is determined by the rating change.
The reason to conduct this study is supported by various reason of interest. Firstly, if
the rating change is predictable by the investors and equity return being considerably
impacted by the rating change, then such identified relationship would be exploited by them
to make abnormal return. When explaining the observed empirical evidence, there is
somewhat breaking down of the financial theory. The role of credit rating agencies in the
capital market is also considered in this study by conducting the examination of informational
value that is generated by rating announcement (Casell et al. 2016).
Research questions:
The research questions that would be addressed in the current research paper are as
follows:
 Does any change in ratings by credit rating agencies enclosed new information?
 Does the announcement of credit rating impacts the return generated on stock
significantly?
 Does the rating provided by the credit rating agencies affect the valuation of the
stock?

THE IMPACT OF CHANGE IN CREDIT RETURN ON STOCK RETURN
Literature review:
The finance literature presents several studies that have investigated the relationship
of the impact of change in credit rating on the capital market specifically in relation to the
developed countries. While some studies intended to measure the impact on the bond and
some other studies focused on examining the impact of return on bond and price. This
particular section demonstrates the review of literature by discussing the theoretical review of
the relationship between stock prices and credit rating, anticipation of market, efficient
market hypothesis. Event study methodology has been used by many researchers for
investigating the impact of upgrade and downgrade of credit rating the return generated by
the stock. In one of the study conducted on identifying the significance of change in credit
rating on the equity and bond market have ascertained that the market do not respond to
positive announcement and only react to downgrades (Pdfs.semanticscholar.org. 2019).
The role of credit rating on bond and equity market:
The working of rating mechanism requires that the credit rating agencies maintain
their reputation as objective and reliable sources of information. An increased rating on the
dependency on the credit rating agencies have been reflected by the intensified criticism
aimed toward such rating agencies resulting from disintermediation process on the financial
market. Prevailing of larger competition between the credit rating agencies with the
expansion of the market has created the temptation to exploit the inherent conflict of business
(Safari and Ariff 2015). Nonetheless, the effect of equity return due to the announcement
should be primarily related to new information amount which are relevant for shareholders
that has been released through the event of credit rating. It is essential to understand the
underlying incentives of the prices of rating for gaining an understanding about the link
between the return pattern on the equity market and the credit ratings. It has been argued that

THE IMPACT OF CHANGE IN CREDIT RETURN ON STOCK RETURN
the perceived reliability of credit rating would influence the abnormal reaction of the price of
shares. Credit rating agencies in particular is concerned with the implicit negative
repercussion of the action of rating agencies. This could provide possible explanation of the
cross sectional variants and explanation of differential effects between downgrades and
upgrades. The rating change should have more pronounced effect of the announcement when
it is associated with the change in upgrading and downgrading of a particular sub category
(Internationaljournalssrg.org. 2019).
A research conducted on the capital market of Australia and Japan for identifying the
relationship between the credit risk and return on stock found that the upgrade of the stock
and stock return is related directly. Another study conducted study on identifying the
relationship between the rating changes and stock return on the banks of US for a period of
twelve years have downgraded to the stock is highly associated with the negative abnormal
return and post the announcement period, the positive return generated by the stock is related
with both downgrade and upgrade (Böninghausen and Zabel 2015).
Many European markets have been investigated for identifying the relationship
between stock return and credit rating and it has been clearly depicted by all such studies that
there is diversity in the in the results of responses to the change in credit rating. In one of the
study investigating the behavior of prices of corporate bonds after the announcement of
change in credit rating implies that the change in rating of bond detecting the market
information should not be generated by market (Baum et al. 2018). However, an evidence of
price was ascertained before the announcement of change in credit rating. However, no
change in the price was found consequent to the rating change announcement. Nonetheless,
little evidence was revealed by the study of the change in price post the announcement.
Furthermore, it is revealed by some other study that the price of stocks is not influenced by
the downgraded of rating of bond. It has been found that in most of the cases, the price of

THE IMPACT OF CHANGE IN CREDIT RETURN ON STOCK RETURN
bond is negatively impacted by the downgrade while there is no impact on the stock price due
to the bind rating upgrades. The results concluded by such studies well align with the logic
that new information to the stock market is notified by the rating downgrades. While no link
has been found between the upgrades of rating on the stock and compared to the existence of
link between the negative abnormal return on stock and credit ratings downgrade. It has been
found that negative abnormal return is generated by the stock during the two day event
window. Similar findings were concluded by another study, however, the detail of rating
were explained in more detail. In this particular study, downgrades were grouped into two.
One downgrade was due to increase in financial leverage while the other was due to the
decay in the financial outlook of company. Companies that have negative reaction for its
equity market are those which have witnessed deterioration in the financial condition as
against those because of increased leverage (Bis.org. 2019).
The empirical validity and the relevance of efficient market hypothesis are being
changed due to the development of capital market. A considerable increasing number of
studies supporting the efficient market hypothesis (EMH) that conducted a time series
analysis on twenty two stocks found that the return generated by the stocks are normal. Many
of the studies on EMH were conducted inefficiency because it was claimed that since there
was existence of cost of information, market could not be efficient. The propensity to invest
would disappear if the return generated on investment is not higher the cost of obtaining
information (Bissoondoyal and Brooks 2015). However, EMH was opposed because of
excess volatility concept. It was concluded that the actual return generated by the stock due to
fluctuation in the price of stock was higher than the return generated based on the
computation of return using fundamental information. The stock price reflects the annulment
made by company as the people tend to overreact to such announcement. However,
sometimes the return generated by the stock can only be explained based on the fundamental

THE IMPACT OF CHANGE IN CREDIT RETURN ON STOCK RETURN
information as the return on stock was higher which was marked by noise traders that created
a significant influence on the stock retune or the market price of stock. The significance of
EMH in the modern financial theory has remained a major subject of discussion and the
trading conditions in the modern stock market are perfectly described by EMH (Kedia et al.
2018). This is so because the execution of trade and flow of information is faster than before.
While on other hand, certain pattern of change in stocks could not be explained by EMH. In
one of the study, the traditional argument of weak form of efficiency has been analyzed for a
set of blue chip companies where the correlation coefficient of the return generated ranges
between negative and positive value and it came with the conclusion that the return on stock
tomorrow is nit influenced by the return generated by the stock today. It can be argued that
the potential differences between the stocks cannot be spotted in such a short time period.
Nevertheless, the result remained unchanged when the return on stocks were analyzed for the
weekly period. The validation of the serial correlation test has been repeatedly validated
when analyzing the return equity indices as well as individual companies. It has been inferred
that since it has become harder to predict stock return, it can be said that stock market is
approaching to market efficiency. For study conducted on one of the stock market analyzing
the return on the stock and financial ratios concluded that the performance of stock market
was reflected by the fundamental information (Naseer and bin Tariq 2015).
The review of the empirical test of EMH has been divided into test on investment
manger and test on prices. Contrary to the null hypothesis of efficiency, evidence has been
occasionally produced using the past pricing behavior of the bond and stock market. This
result has suggested that EMH might not hold all time and for all the market. The role played
by the risk factor in determining the expected future return generated on investment have
been stressed out by asset pricing theory and capital asset pricing model. In addition to this,
the value of credit rating announcement was investigated by taking into account the factors

THE IMPACT OF CHANGE IN CREDIT RETURN ON STOCK RETURN
such as liquidity and market capitalization. Using the event study methodology in one of the
research papers analyzing the impact of stock market of change in corporate bond rating in
Australian and UK stock market found that both the markets have been downgraded because
of significant announcement. On other hand, another study determining the impact of bond
rating on the return generated by stock that the downgrade of bond is associated with
insignificant abnormal return. It is therefore concluded by such research that no important
information is conveyed because of the upgrade or downgrade of the bond (Cfainstitute.org
2019).
From the analysis of the literature review, it can be concluded that the earlier studies
determining the impact of change in credit rating on the return generated by the stock either
generated mixed evidence or there was no effect at all. The findings of such studies
concluded that several of the rating actions happen after the announcement or when the
events are known to public (Chittoor et al. 2015). In the methodologies adopted by recent
studies, it was found that the rating actions of agencies are break down into the sub groups
because of inaccurate information or because such action was forgiven by the credit agencies.
In addition to this conclusion, it was corroborated by the findings that while upgrade do not
implies any significant change, new information were reflected by the abnormal return
provided by the upgrade.
Methodology:
In this section, the technique used by researcher to conduct the research has been
outlined. Research methodology is the procedure that is adopted by research to carry out the
investigation in an organized and systematic manner. For conducting the analysis, then
researched would adopt empirical approach and this is followed by the data base choice,
methodology for credit rating and collection of data (Wengner 2015). Firstly, the event would

THE IMPACT OF CHANGE IN CREDIT RETURN ON STOCK RETURN
be defined by the researcher and then the firm or sector would be selected for conducting the
study and event window would be defined.
The research design would be divided into following steps:
 The information on bond rating instrument would be taken for particular sector that is
bank for a period of ten years by using several databases. In addition to this, the
market price of share that is monthly, daily and weekly data is collected from various
stocks of banking sector. For deriving the data, the right database should be chosen.
The primary source of collecting data is Bloomberg and the researcher would be able
to download the stock price along with historical credit ratings with the help of built
in function of the website (Tahmoorespour et al. 2018).
 The second section of the research design is to ascertain that when the credit rating
agencies have announced the credit rating changes. Research has analyzed the impact
of information generated by rating change on the market price of share by computing
the change in return of 50 days before and after the announcement of rating change.
 The average abnormal return is computed as the difference between the market model
and actual return for determining the impact of announcement of credit rating
downgrade (Driss et al. 2016).
The aggregate abnormal return generated by the stock would be computed by
summing up the daily returns and thereafter the significant impact would be analyzed. For
analysis the data collected that is to evaluate the event introduced change in the variances, the
researcher would be employing standardized cross sectional test to determine the abnormal
return generated by the chosen stock is considerably different from zero (Hu 2017).

THE IMPACT OF CHANGE IN CREDIT RETURN ON STOCK RETURN
Ethical considerations:
Ethical consideration can be regarded as one of the crucial part of research which
would be addressed by researcher in an effective manner. While conducting the research,
researcher would be taking into account all the ethical aspects from collecting, fetching and
analyzing data. The data involving ethical issues would be more challenging as it would be
resulting in compromising the analysis of data and their interoperation. The researcher while
considering ethical data would take into account the future and current use of data and would
try to maintain high ethical standard while carrying out research work so that the framework
developed would result in ethical decision making. While carrying out research work,
researcher would prioritize to maintain the dignity of participants of research along with
ensuring their protection of privacy. It would be ensured by the researcher that adequate level
of confidentiality is maintained when collecting the research data. Furthermore, researcher
would avoid any kind of aggregation and deception about the objectives and aims of research.
Any type of presentation of primary data in a biased way and misleading information would
also be avoided by researcher (Chodnicka 2016).
Expected outcome:
From the analysis of results obtained by reviewing literature review, it can be inferred
that the research paper would generate mixed view about the return generated by the stock
due to upgrade and downgrade of stocks. There might ambiguous discussion on how the
stock return would be impacted by credit risk. It is also apparent that this field of study would
generate interesting results that would generate future research. Although the finance
literature has established the relationship the stock market reaction and changes in credit
rating, this particular research paper would concentrate on identifying the reaction of the
stock of banking sector in UK and the change in credit rating agencies. Therefore, the

THE IMPACT OF CHANGE IN CREDIT RETURN ON STOCK RETURN
findings generated would be confined to one particular country that is United Kingdom which
might limit the generalizability of the result. Moreover, it would be required to conduct future
study that would conduct a comparative study on cross countries for examining the
relationship between return of stock market and changes in credit rating. Moreover, the
assessment of the impact of price of rating actions for particular country may serve for
sensitivity checking and would provide insights into the financial markets authorities for
evaluating the usage of rating agencies as regulatory tool.

THE IMPACT OF CHANGE IN CREDIT RETURN ON STOCK RETURN
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