Rating Under Asymmetric Information
88 Pages Posted: 16 Jun 2017 Last revised: 31 Dec 2017
Date Written: June 15, 2017
We study a dynamic signaling game where a firm, by its decision to stay solvent, signals its quality to a rating agency with the rating feeding back into the firm’s cost of capital. Observing the firm’s true cash flow blurred by a persistent measurement error, the error-minimizing rating agency learns dynamically through the firms solvency decision. Firms with higher measurement error default earlier, inducing directional learning by successively eliminating overestimated measurement errors. In a partially separating perfect Bayesian equilibrium in Markov strategies, the firm employs a measurement-error dependent cut-off strategy. We discuss the extensive economic consequences of such a learning mechanism.
Keywords: Rating, Performance Sensitive Debt, Asymmetric Information, Learning, Markov Perfect Bayesian Equilibrium
JEL Classification: G12, G14, G32
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