Working Paper No. 00012-00
We provide a novel interpretation of the role of credit ratings when contracts between investors and portfolio managers are incomplete. In our model, a credit rating on a bond provides a verifiable signal about an unverifiable state. We show that the rating will be contracted on only if it is sufficiently precise. Moderately precise ratings lead to wage contracts, and highly precise ones to contracts which directly restrict managers actions. In a market-wide equilibrium, surplus in the investor-manager transaction may decline when ratings become more precise. The widespread of use of credit ratings leads to excess volatility in bond returns.