OPTIMAL CREDIT RATINGS

Sebastian Herzog (), Christian Koziol () and Tim Thabe ()
Additional contact information
Sebastian Herzog: University of Mannheim, L 5, 2, D-68131 Mannheim, Germany
Christian Koziol: WHU — Otto Beisheim School of Management, Burgplatz 2, D-56179 Vallendar, Germany
Tim Thabe: Goldman Sachs International, Peterborough Court, 133 Fleet Street, London EC4A 2BB, United Kingdom

International Journal of Theoretical and Applied Finance (IJTAF), 2008, vol. 11, issue 02, 225-247

Abstract: In this paper, we show that an individual optimal credit rating exists for firms and empirically test whether firms strive to achieve their optimal rating. For this purpose, we consider the structural model by Leland [12], which balances the benefits of debt in the form of the tax-deductibility of interest payments against bankruptcy costs in order to obtain the optimal rating. Testable implications for both firms which have implemented their optimal rating and firms with non-optimal ratings are deduced. An empirical test with 420 firms contained in the S&P 500 Index indicates that all factors which theoretically drive optimal ratings also affect the observed rating in the predicted way. In line with our theory, observed ratings can be considerably better explained if, in addition to the traditional factors such as leverage and firm size, a proxy for bankruptcy costs and the default probability related to the optimal rating is considered. These findings suggest that U.S. firms contained in the S&P 500 Index strive to achieve their optimal credit ratings.

Keywords: Optimal versus non-optimal credit ratings; structural model; empirical test of optimal credit ratings; rating prognosis (search for similar items in EconPapers)
Date: 2008
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Citations: View citations in EconPapers (1)

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DOI: 10.1142/S0219024908004786

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