Contracting on Credit Ratings: Adding Value to Public Information
49 Pages Posted: 1 Nov 2014 Last revised: 30 Jan 2019
Date Written: January 28, 2019
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.
Keywords: credit rating, incomplete contract
JEL Classification: G24, D86
Suggested Citation: Suggested Citation