Dynamic Rating with Feedback Effects

85 Pages Posted: 16 Jun 2017 Last revised: 11 May 2019

See all articles by Christian Hilpert

Christian Hilpert

Sun Yat-Sen University (SYSU) - Lingnan (University) College

Stefan Hirth

Aarhus University; Danish Finance Institute

Alexander Szimayer

University of Hamburg - Faculty of Economics and Business Administration

Date Written: May 8, 2019

Abstract

In a dynamic signaling game, a rating agency observes a firm’s cash flow blurred by a persistent measurement error. Higher measurement errors imply earlier default. The firm’s owner can signal quality by cash injection in distress. With Bayesian directional learning, the rating agency eliminates high measurement errors, resulting in a lower cost of capital for the same level of observed cash flow. Thus, the rating feeds back into the owner’s cash injection decision and vice versa. The model provides a novel explanation for rating inflation and delayed default at lower asset values, despite the rating agency aiming for unbiased ratings.

Keywords: Rating, Asymmetric Information, Learning, Feedback Effect

JEL Classification: G24, G33, D83

Suggested Citation

Hilpert, Christian and Hirth, Stefan and Szimayer, Alexander, Dynamic Rating with Feedback Effects (May 8, 2019). Available at SSRN: https://ssrn.com/abstract=2986850 or http://dx.doi.org/10.2139/ssrn.2986850

Christian Hilpert (Contact Author)

Sun Yat-Sen University (SYSU) - Lingnan (University) College ( email )

Guangzhou
China

Stefan Hirth

Aarhus University ( email )

Fuglesangs Alle 4
Aarus, 8210
Denmark

HOME PAGE: http://hirth.dk

Danish Finance Institute ( email )

Alexander Szimayer

University of Hamburg - Faculty of Economics and Business Administration ( email )

Von-Melle-Park 5
Hamburg, 20146
Germany

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