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Do Credit Rating Agencies Learn from the Options Market?

Author

Listed:
  • Paul Brockman

    (Finance, Lehigh University, Bethlehem, Pennsylvania 18015)

  • Musa Subasi

    (Accounting and Information Systems, University of Maryland-College Park, College Park, Maryland 20742)

  • Jeff Wang

    (School of Accountancy, San Diego State University, San Diego, California 92182)

  • Eliza Zhang

    (Milgard School of Business, University of Washington Tacoma, Tacoma, Washington 98402)

Abstract

Do credit rating agencies (CRAs) learn from the options market? We examine this question by exploring the relation between options trading activity and credit rating accuracy. We find that as options trading volume increases, credit ratings become more responsive to expected credit risk and exhibit greater ability to predict future defaults. We also find that CRAs rely more on the options market as a source of ratings-related information when firm default risk is higher, options trading is more informative, manager-provided information is of lower quality, and firm uncertainty is higher. Our results are robust to a number of sensitivity tests, including alternative measures of options trading and credit rating accuracy. We reach similar inferences using various approaches to address endogeneity issues, including difference-in-difference analyses and an instrumental variables approach. Overall, our findings are consistent with the view that CRAs incorporate unique information from the options market into their rating decisions which, in turn, improves credit rating accuracy.

Suggested Citation

  • Paul Brockman & Musa Subasi & Jeff Wang & Eliza Zhang, 2024. "Do Credit Rating Agencies Learn from the Options Market?," Management Science, INFORMS, vol. 70(11), pages 7851-7867, November.
    • Handle: RePEc:inm:ormnsc:v:70:y:2024:i:11:p:7851-7867
    DOI: 10.1287/mnsc.2023.4980
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