We derive an equilibrium asset pricing model incorporating liquidity risk, derivatives, and short-selling due to hedging of nontraded risk. We show that illiquid assets can have lower expected returns if the short-sellers have more wealth, lower risk aversion, or shorter horizon. The pricing of liquidity risk is different for derivatives than for positive-net-supply assets, and depends on investors' net nontraded risk exposure. We estimate this model for the credit default swap market. We find strong evidence for an expected liquidity premium earned by the credit protection seller. The effect of liquidity risk is significant but economically small.

Credit Rating Agencies (CRAs) report information about the credit risk of fixed income securities. The various ways the information is used by financial, legal and regulatory entities may potentially influence the nature of the information production process. Bond ratings are not only used to assess risk, they are also used for regulatory certification, e.g. to classify securities into investment grade (IG) and high yield (HY, or junk) status. These classifications in turn influence institutional demand and serve as bright-line triggers in corporate credit arrangements and regulatory oversight. Regulations may mandate insurance companies and banks to keep much higher reserve capital for high yield issues than for investment grade corporate bonds. Other institutions like pension funds and mutual funds are often restricted by their charters in the amount of HY debt they can hold. Taken together, more than half of all corporate bonds are held by institutions that are subject to rating-based restrictions on their holdings of risky credit assets (Campbell and Taksler (2003)). Lower demand for high yield bond can significantly increase the cost of borrowing for those issuers and is related to capital structure decisions (see Ellul, Jotikasthira and Lundblad (2009), Kisgen and Strahan (2009), Kisgen (2006, 2009)). The institutional and regulatory importance of credit ratings to issuers and investors has raised questions about whether the current system provides the proper incentives for issuers to fully disclose value-relevant information, and for investors to invest in research about credit risk. Using a sample from 2000-2008, we document that almost all large, liquid US corporate bond issues are rated by both S&P and Moody's. Fitch typically plays the role of a "third opinion" for large bond issues 1. During the time period the most prevalent institutional rule used for classifying rated bonds was that, if an issue has two ratings, only the lower rating could be used to classify the issue (e.g. into investment-grade or non-investment grade). However, for issues with three ratings, the middle rating should be used (see, for example, the NAIC guidelines or the Basel II accord). 2 Therefore, if S&P and Moody's ratings are on opposite sides of the investment grade boundary, the Fitch rating (assuming it is the marginal, third rating) is the 'tie-breaker' and will decide into which class the issue falls. Moreover, this rule directly implies that adding a third rating cannot worsen the regulatory rating classification, but could potentially lead to a higher one. Consistent with this option, we find that in about 25% of Fitch rating additions, the addition leads to a regulatory rating improvement, i.e., the resulting middle rating is higher than the lowest rating before the Fitch rating addition. Ex ante, such an improvement would be particularly important when S&P and Moody's ratings are on opposite sides of the investment grade boundary. Absent the improving third rating, the split between S&P and Moody's would result in a...

This paper explores the economic role credit rating agencies play in the corporate bond market. We consider three existing theories about multiple ratings: information production, rating shopping, and regulatory certification. Using differences in rating composition, default prediction, and credit spread changes, our evidence only supports regulatory certification. Marginal, additional credit ratings are more likely to occur because of, and seem to matter primarily for, regulatory purposes. They do not seem to provide significant additional information related to credit quality.CREDIT RATING AGENCIES (CRAS) REPORT information about the credit risk of fixed income securities. The various ways the information is used by financial, legal, and regulatory entities may potentially influence the nature of the information production process. Bond ratings are used not only for risk assessment, but also for regulatory certification, that is, for classification of securities into investment grade (IG) and high yield (HY, or junk) status. These classifications in turn influence institutional demand and serve as bright-line triggers in corporate credit arrangements and regulatory oversight. Regulations may mandate that insurance companies and banks keep much higher reserve capital for HY issues than for IG corporate bonds. Other institutions such as pension funds and mutual funds are often restricted by their charters with respect to the amount of HY debt they can hold. Taken together, more than half of all corporate bonds are held by institutions that are subject to rating-based restrictions on their holdings of risky credit assets (Campbell and Taksler (2003)). Lower * Bongaerts is with Finance Group, RSM Erasmus University Rotterdam, and Cremers and Goetzmann are with the International Center for Finance, Yale University. We would like to thank Patrick Behr; Michael Brennan; Mark Carlson; Erwin Charlier; Long Chen; Frank de Jong; Joost Driessen; Frank Fabozzi; Rik Frehen; Gary Gorton; Jean Helwege; Mark Huson; Ron Jongen; Pieter Klaassen; David Lesmond; Hamid Mehran; Catherine Nolan; Frank Packer; Ludovic Phalippou; Paolo Porchia; Jörg Rocholl; Joao Santos; Joel Shapiro; Chester Spatt; Walter Stortelder; Dan Swanson; Anjan Thakor; Laura Veldkamp; Evert de Vries; Jacqueline Yen; Weina Zhang; as well as conference participants at the Financial Crisis conference at Pompeu Fabra University, the European Finance Association annual meetings in Bergen (Norway, 2010), the Texas Finance Festival at UT Austin, the RMI conference at National University of Singapore, the NBER meeting on Credit Ratings in Cambridge, the Conference on Credit Rating Agencies at Humboldt University, the American Finance Association annual meetings in Denver (2011); and seminar participants at the University of Amsterdam, Rotterdam School of Management, and the Dutch National Bank for helpful comments and information. We especially thank Campbell Harvey (the Editor), an anonymous associate editor, and an anonymous referee for many helpful comments...

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