Working Paper No. 265
By Spyros Pagratis
Using an intertemporal model of asset pricing under asymmetric information, we demonstrate how public ratings about the quality of a risky asset could enhance information efficiency, albeit at a cost of higher asset price volatility. The analysis also draws implications for the use of ratings for benchmarking purposes, in particular, ratings-based capital requirements and an investment/subinvestment grade dichotomy depending on the rating of the asset. In this situation, allowing a class of market participants (eg pension funds) to hold an asset only if its rating exceeds a certain threshold may lead informed traders to overreact to news about fundamentals. In this case, ratings induce lower price efficiency and excessive asset price volatility.
Asset pricing, asymmetric information and rating announcements: does benchmarking on ratings matter?