Contracting on Credit Ratings: Adding Value to Public Information

49 Pages Posted: 1 Nov 2014 Last revised: 30 Jan 2019

See all articles by Christine A. Parlour

Christine A. Parlour

University of California, Berkeley - Finance Group

Uday Rajan

Stephen M. Ross School of Business, University of Michigan

Date Written: January 28, 2019

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.

Keywords: credit rating, incomplete contract

JEL Classification: G24, D86

Suggested Citation

Parlour, Christine A. and Rajan, Uday, Contracting on Credit Ratings: Adding Value to Public Information (January 28, 2019). Available at SSRN: https://ssrn.com/abstract=2516940 or http://dx.doi.org/10.2139/ssrn.2516940

Christine A. Parlour

University of California, Berkeley - Finance Group ( email )

Haas School of Business
545 Student Services Building
Berkeley, CA 94720
United States
510-643-9391 (Phone)

Uday Rajan (Contact Author)

Stephen M. Ross School of Business, University of Michigan ( email )

701 Tappan Street
Ann Arbor, MI 48109
United States
734-764-2310 (Phone)

HOME PAGE: http://webuser.bus.umich.edu/urajan

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