Rating Under Asymmetric Information - Inflation Despite Best Intentions

68 Pages Posted: 16 Jun 2017 Last revised: 3 Jul 2017

Christian Hilpert

University of Hamburg

Stefan Hirth

University of Aarhus

Alexander Szimayer

University of Hamburg - Faculty of Economics and Business Administration

Date Written: June 15, 2017

Abstract

We analyze how a firm’s reputation and track record affect its rating and cost of debt. We model a setting in which outsiders such as a rating agency and the firm’s creditors continuously update their assessment of the firm’s true state described by its cash flow. They observe the latter only imperfectly due to asymmetric information. Other things equal, the rating agency optimally rates a firm with the same observed cash flow higher, if the historical minimum is sufficiently low. Thus, the rating is not only driven by the most recent information, but history matters. The rating agency refines its unbiased cash flow estimate by ruling out the most overestimated types, leading to an overestimation at default. In response, the firm delays default and lower asset values are available to creditors upon default.

Keywords: Rating, Performance Sensitive Debt, Asymmetric Information, Learning, Markov Perfect Bayesian Equilibrium

JEL Classification: G12, G14, G32

Suggested Citation

Hilpert, Christian and Hirth, Stefan and Szimayer, Alexander, Rating Under Asymmetric Information - Inflation Despite Best Intentions (June 15, 2017). Available at SSRN: https://ssrn.com/abstract=2986850

Christian Hilpert (Contact Author)

University of Hamburg ( email )

Von-Melle-Park 5
Hamburg, 20146
Germany

HOME PAGE: http://christianhilpert.de

Stefan Hirth

University of Aarhus ( email )

Nordre Ringgade 1
Aarhus, DK-8000
Denmark

Alexander Szimayer

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

Von-Melle-Park 5
Hamburg, 20146
Germany

Paper statistics

Downloads
25
Abstract Views
186