Rating Under Asymmetric Information
88 Pages Posted: 16 Jun 2017 Last revised: 18 Apr 2018
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 firm’s solvency decision. Firms observed with higher measurement error default earlier, inducing directional learning by successively eliminating measurement errors which are too high to be feasible. 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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