Are the Standards Too Poor? An Empirical Analysis of the Timeliness and Predictability of Credit Rating Changes

Abstract:     
In this paper we investigate the dynamics of credit rating changes by Standard & Poor's (S&P) for all 583 companies that were included in the S&P 500 index between July 1998 and June 2003. Our analysis shows that KMV Corporation, a 'new' entrant to the credit rating industry that uses a quantitatively oriented, market-based approach to credit risk measurement, provides a significantly timelier insight into companies' credit quality changes than the qualitatively oriented, accounting-based approaches used by S&P. Based on a sample of 690 rating changes reported by S&P during the sample period, we show that 75% of the S&P rating changes are significantly anticipated by KMV more than a year in advance. Furthermore, we test for the predictability of S&P's rating changes. We show that KMV's Expected Default Frequencies possess considerable predictive power to forecast future rating changes by S&P.

Keywords: Credit ratings, predictability, credit rating agencies

JEL Classifications: G14, G28

Working Paper Series