Sovereign Debt Rating Changes and the Stock Market

We use an event-study methodology to analyze the effect of sovereign debt rating changes on daily stock market returns around the world. We find evidence that the stock market moves before the public announcement of a sovereign rating downgrade, resulting in a significant market reaction prior to the event, weak reaction at the event and a mild correction after the event. The results are much weaker for upgrades. Using instrumental variables techniques we build a causal case to argue that these findings are more pronounced in non-developed markets, in countries with civil (relative to common) law systems, lower measures of law and order institutional quality, and higher measures of corruption.