Equity Short Selling and Bond Rating Downgrades
48 Pages Posted: 15 Mar 2010 Last revised: 20 Feb 2014
Date Written: February 19, 2014
We examine whether short sellers identify firms that have significant changes in default likelihoods and credit rating downgrades. In the month before a rating downgrade, equity short interest is 40% higher than one year prior. Short sellers predict changes in default probabilities that lead to downgrades by focusing on firms with inaccurate or biased ratings. This strategy is profitable for short sellers primarily since downgrades are associated with significantly negative equity returns. Short sellers also facilitate price discovery by reducing abnormal stock returns following downgrades and by leading bond yield spreads.
Keywords: Credit ratings, default risk, short selling, price discovery, informed trading
JEL Classification: G12, G14, G24
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