Do Credit Rating Agencies Learn from the Options Market?

Paul Brockman (), Musa Subasi (), Jeff Wang () and Eliza Zhang ()
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Paul Brockman: Finance, Lehigh University, Bethlehem, Pennsylvania 18015
Musa Subasi: Accounting and Information Systems, University of Maryland-College Park, College Park, Maryland 20742
Jeff Wang: School of Accountancy, San Diego State University, San Diego, California 92182
Eliza Zhang: Milgard School of Business, University of Washington Tacoma, Tacoma, Washington 98402

Management Science, 2024, vol. 70, issue 11, 7851-7867

Abstract: Do credit rating agencies (CRAs) learn from the options market? We examine this question by exploring the relation between options trading activity and credit rating accuracy. We find that as options trading volume increases, credit ratings become more responsive to expected credit risk and exhibit greater ability to predict future defaults. We also find that CRAs rely more on the options market as a source of ratings-related information when firm default risk is higher, options trading is more informative, manager-provided information is of lower quality, and firm uncertainty is higher. Our results are robust to a number of sensitivity tests, including alternative measures of options trading and credit rating accuracy. We reach similar inferences using various approaches to address endogeneity issues, including difference-in-difference analyses and an instrumental variables approach. Overall, our findings are consistent with the view that CRAs incorporate unique information from the options market into their rating decisions which, in turn, improves credit rating accuracy.

Keywords: credit rating; credit risk; default probability; credit rating accuracy; options market (search for similar items in EconPapers)
Date: 2024
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