Credit Rating Downgrade Risk on Equity Returns

Abstract

We develop an asset pricing model to capture credit rating downgrade risk and suggest a new methodology to generate firm-level downgrade probabilities. Using credit transition matrices and rating histories from US issuers, we provide empirical evidence for a statistically significant positive downgrade risk premium. Stocks at higher risk of failure tend to deliver higher returns. The performance of the model remains robust across several panel data estimation methods. Panel Granger causality test results further indicate a Granger-causal relationship from credit rating transition probabilities to excess returns. Our paper thus provides the basis for further development and empirical validation of Fama-French-type models under financial distress.

Keywords: Asset Pricing, Credit Risk, Panel Data, Stock Returns, Transition Matrices

JEL Classification: G11, G12, G14, G41