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Sovereign debt rating. Sovereign debt ratings are assessments of the probability of default in government bonds. Rating agencies consider economic and political factors and make a qualitative and quantitative evaluation. - PowerPoint PPT Presentation


  • Sovereign Debt Rating and Stock Liquidity around the WorldPresentation atatSchool of International Business AdminstrationShanghai University of Finance and EconomicsJune 27, 201310:00amby Yangru Wu (Rutgers University)

    Co-authors: Kuan-Hui Lee (Korean University)Horacio Sapriza (Federal Reserve Board)*

  • Sovereign debt ratingSovereign debt ratings are assessments of the probability of default in government bonds. Rating agencies consider economic and political factors and make a qualitative and quantitative evaluation.By doing so, sovereign debt rating changes deliver new information about a country, as evidenced by their significant effects on:Stock market returns: Kaminsky and Schmukler (2002), Brooks, Faff, Hiller, and Hiller (2004), Martell (2005)Individual stock returns: Martell (2005), Lee, Sapriza, and Wu (2010)Bond yields/spreads: Cantor and Packer (1996), Larrain, Reisen, and von Maltzan (1997), Gande and Parsley (2005)*

  • This paper is about However, there are no studies investigating the effect of sovereign debt rating changes on stock liquidity. Our paper fills in that gap.We study the impact of changes in sovereign credit ratings on daily stock liquidity for 40 developed and emerging markets from January 1990 to December 2009. Stock-level analysis: Cross-sectional variation of impactCross-country analysis: differences in response over countriesRegression approach rather than event-study framework (Gande and Parsley, 2005)The importance of liquidity has been growing rapidly both for researchers and for practitioners.*

  • Why is liquidity important?

    Whenever the market turns against you, you take the biggest losses in illiquid securities, says Richard Bookstaber, former head of risk management at Salomon Bros. Because there are so few buyers, youre forced to sell at a discount that is both huge and highly unpredictable. (Fortune, November 26, 2007)

    Liquidity affects asset prices.Amihud and Mendelson 1986, Brennan et al 1996, Amihud 2002, Pastor and Stambaugh 2003, Acharya and Pedersen 2005, Lee 2011Liquidity is systematic, and its commonality may lead to the fragility of financial markets.Brunnermier and Pedersen 2009, Hameed, Kang, and Viswanathan 2010, Karolyi, Lee, and van Dijk 2010Liquidity affects market efficiency.Chordia et al 2008*

  • How could rating changes be related to liquidity?Sovereign debt ratings impose a significant externality to the countrys private sector, which can affect investors incentives to hold stocks. Especially, sovereign downgrades may lead to:Capital outflows (Reinhart and Rogoff, 2004; Kim and Wu, 2008; Gande and Parsley, 2010), which may be accompanied by fire sales of assets, thus, liquidity constraint (Pastor and Stambaugh, 2003; Acharya and Pedersen, 2005)

    Low ratings are related to high adverse selection, thus to low liquidity in equity (Odders-White and Ready, 2006).In times of market stress, bond investors chase liquidity (flight-to-liquidity), not credit quality (Beber, Brandt, and Kavajecz, 2009)Low ratings are also related to low liquidity in bonds (Cantor and Packer, 1996)*

  • How rating changes could be related to liquidity? Sovereign downgrades may lead to limited access to international capital markets (Dittmar and Yuan, 2008), which, in turn, limits liquidity due to limited diffusion of information in the global capital markets (high information asymmetry).Sovereign ceiling lite (Ferri , Lui, and Majnoni, 2001; Ferri and Liu, 2002; Kaminsky and Schmukler, 2002; Borensztein, Cowan, and Valenzuela, 2007)More information asymmetry at the time of earnings announcement (Kim and Verrecchia, 1994)Funding constraints of traders (e.g., hedge funds, banks, market-makers) affect, and are affected by, market liquidity:Intermediaries make markets by absorbing liquidity shocks subject to funding constraints (via posted margins on collateral). When markets decline and if funding constraints bind, they endure loss in collateral values, margin limits are hit, thus forcing them to liquidate positions. One traders hitting his limit in one security leads to falling prices and greater illiquidity in other securities and makes other traders hit their respective limits; liquidity spirals or liquidity black holes arise.Brunnermeier and Pedersen (2009), Gromb and Vayanos (2002), Kyle and Xiong (2001), Morris and Shin (2004), Hameed, Kang, and Viswanathan (2010), Karolyi, Lee, and van Dijk (2010)*

  • OutlineData and sovereign debt ratingsLiquidity measureFiltering seasonal effect of liquidityEmpirical resultsRating changes and their impact on liquidityAsymmetric impact of rating changes on liquidityNonlinear impact of rating changes on liquidityCross-sectional differences of effects on stock liquidityCross-country differences of effects on stock liquidityConclusion


  • DataSovereign rating data from S&PS&P rating is more active and tends to precede other rating agencies (Brooks et al., 2004; Gande and Parsley, 2005)Total 424 event days Datastream/Worldscope for 1990-2009 from 40 countries (26 emerging and 14 developed markets)Including dead-stocks (free of survivorship bias)Require: only common shares listed in major exchangesavailable total return index, trading volume, market value of equity, and B/MExclude:if daily return or trading volume is at 1% extreme in a given countrynon-trading daysobservations for non-event daysFinal Sample: 67,518 stock-event days*

  • Numeric conversion of ratingsEvent=absolute value of changes in ratingsE.g. Brazil: BB+/Positive (June 12, 2007), BBB-/Stable (Apr 30, 2008)


  • Table 1. Number of events by countryEvent+:upgrade


    Event Big+:upgrade by morethan 2 notches

    Event Big-:downgrade by more than 2notches


  • Event clustering and regression framework Many previous studies perform event-study analyses.Cantor and Packer (1996), Brooks et al. (2004), Martell (2005)

    However, clustering of events may contaminate event-windows.E.g. Argentina: 2001/10/9 (CCC+/Neg), 2001/10/30 (CC/Neg), 2001/11/6 (SD/NM=Not meaningful)

    Hence, following Kaminsky and Schmukler (2002) and Gande and Parsley (2005), we adopt a regression framework:Change in liquidityi,t = a + b*Eventi,t + ei,t


  • Liquidity measure and its seasonalityIlliquidity measure from Amihud (2002)Popular price impact measure:Hasbrouck (2005), Goyenko et al. (2009) Can be computed at daily frequency.By taking log, we use:Illiquidity has day-of-the-week effect and seasonality with calendar month.Chordia et al. (2005), Hameed et al. (2010)Hence, we run the following filtering regression:

    By taking first-differences of residuals,


  • Table 2. Filtering regression*

  • Table 3. Descriptive statistics*

  • HypothesesIf sovereign rating changes deliver new information to the market, investors will repackage their portfolio, hence stock liquidity will drop on event.The effect of sovereign rating changes will be asymmetric: downgrades will have a larger impact than upgrades.Reluctant to downgrade, hence downgrading delivers more information -> larger effect on portfolio rebalancing needsDowngrades limit access to international financial market, increasing information asymmetryDowngrades may lead to a higher level of funding constraintsThe effect of sovereign rating changes will be non-linear: large downgrades will have a larger impact than small downgrades. The effect of sovereign rating changes will be non-linear: rating changes from investment grade to non-investable grade (or vice versa) will have a larger impact than rating changes not involving investment grade changes.*

  • Rating changes and stock liquidity (Table 4)Country dummy: Yes, Year dummy: YesEvent=absolute value of changes in ratings


  • Asymmetric effect on stock liquidity (Table 4)Event(+)=positive changes, zero otherwiseEvent(-)=absolute value of downgrade, zero otherwiseCountry dummy: Yes, Year dummy: Yes*

  • Nonlinear effect on stock liquidity (Table 5)Big+ (-) Event=absolute value of changes in ratings by more than 2 notches upward (downward), zero otherwise

    Small+ (-) Event=absolute value of changes in ratings by less than 2 notches upward (downward), zero otherwiseCountry dummy: Yes, Year dummy: Yes*

  • Investable -> Non-investable or vice versa (Table 5)Event(Inv->Non-inv)=1 if the change is from investable to non-investable rating, and zero otherwiseEvent(Non-inv->Inv)=1 if the change is from non-investable to investable rating, and zero otherwiseCountry dummy: Yes, Year dummy: Yes*

  • Cross-sectional differences in response Firms with the following characteristics will have smaller impact on events:Politically-connectedPolitically-connected firms are more likely to be bailed out (Faccio, 2006)Large-cap; High transparencyInformation effect by rating changes will be smallerLow book-to-market, High profitabilityLess likely to default, hence smaller incentive to rebalanceNot closely-heldMore free-floating shares, hence easier to trade LiquidLess liquidity constraint *Reinhart, Carmen, and Kenneth Rogoff, 2004. "Serial Default and the Paradox of Rich-to-Poor Capital Flows," American Economic Review, Papers and Proceedings, 53-58.

  • Cross-sectional differences in response (Table 6)Controls: Global market returns log(MV)log(B/M)VolatilityCountry dummiesYear dummies*

  • Cross-country analyses Stocks from the following type of country will experience a smaller impact (ie., less commonality in liquidity) on events:High transparencyRevision in expectations from new information delivered by rating changes will be smaller either due to smaller sensitivity of expectations to new information in transparent setting or due to smaller amo


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