Abstract
This article shows that studies of announcement effects of bond rating changes should take into account the rating prior to the announcement. First, we provide theoretical support for different price effects as a non-linear function of the prior credit rating, using a structural, Merton-type model linking the change in default probability to the change in the stock price. Next, we show that this theoretical prediction is verified in the empirical data. We find much stronger information effects, measured by stock price effects, for rating changes for low-rated firms relative to high-rated firms. Accounting for the role of the rating prior to the announcement explains in large part the puzzling empirical regularity that stock price effects are associated with downgrades but not upgrades. In addition, it eliminates the investment-grade barrier effect reported in previous studies. <b>TOPICS:</b>Fixed income and structured finance, quantitative methods, credit risk management
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