Estimation of Distress Costs Associated with Downgrades Using Regime Switching Models

We use a unique dataset of bond downgrades from a niche rating company that has been found to be reacting faster to publicly available information than its competitors. Using regime-switching models we propose risk measures to quantify stock return disturbances (distress costs) associated with the timing of downgrades. These risk measures are based on the Capital Asset Pricing Model (CAPM) and use the estimated parameters of the regime-switching models in a method that resembles a dynamic event study. We observe a noticeable switch from a low-volatility to a high-volatility regime one day before the day of downgrades. On average the volatility in stock returns triples around the time of downgrades and the stock return process remains in the high-volatility regime for about three days....