Negative Abnormal Equity Returns Following Downgrades
A number of papers show that abnormal equity returns following downgrades are negative. This phenomenon is considered an anomaly, since downgrades are considered to imply an increase in a firm's default risk. In my paper "Equity Returns Following Changes in Default Risk: New Insights into the Informational Content of Credit Rating Changes" (co-authored with Yuhang Xing), we show that this phenomenon is purely due to the way previous papers computed abnormal returns. We present interesting facts about the evolution of default probabilities around downgrades. We also show that when the variation in default risk around downgrades is taking into account when one computes abnormal returns, then those abnormal returns disappear in short and medium horizons. Furthermore, when we also take into account subsequent downgrades following the initial one, the abnormal negative returns disappear completely. In other words, there is no anomaly!
