Contracting on Credit Ratings: Adding Value to Public Information

Christine A Parlour and Uday Rajan

The Review of Financial Studies, 2020, vol. 33, issue 4, 1412-1444

Abstract: We consider the role of credit ratings when contracts between investors and portfolio managers are incomplete. In our model, a credit rating and a price on a risky bond both provide verifiable signals about a non-contractible state. We allow the investor to both impose ex ante restrictions on the manager’s action and provide outcome-based compensation. The optimal contract is a prohibitive one when the rating and price indicate a high likelihood of a low state, and relies on wages when the low state is less likely. We provide some observable implications of our contracting approach to ratings.Received May 10, 2016; editorial decision April 17, 2019 by Editor Itay Goldstein.

Date: 2020
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The Review of Financial Studies is currently edited by Itay Goldstein

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