Title: Credit rating downgrade risk on equity returns
Authors: Periklis Brakatsoulas - Charles University, Faculty of Social Sciences (Czech Republic) [presenting]
Abstract: A four-factor model directed at capturing the size, value, and rating transition patterns in average stock returns performs better than the three-factor model of Fama and French for a panel of 48 small-cap U.S. entities. Using rolling-average flow rates to derive quarterly cohort transition matrices, we provide evidence to support a statistically significant negative downgrade risk premium in excess returns indicating that stocks at high risk of failure tend to deliver lower returns. The model's performance remains robust across several estimation methods. Whilst panel Granger non-causality tests provide no evidence to support the causal relationship in either direction between excess returns and rating transition probabilities, the basis for further empirical validation and development of the FF-type models under distress intensity are provided.