COWLES FOUNDATION FOR RESEARCH IN ECONOMICS
AT YALE UNIVERSITY

Box 208281
New Haven, CT 06520-8281

COWLES FOUNDATION DISCUSSION PAPER NO. 1506

Courage to Capital?
A Model of the Effects of Rating Agencies on Sovereign Debt Roll-over

Mark Carlson
Board of Governors of the Federal Reserve
Galina Hale
Yale University.

April 2005

We propose a model of rating agencies that is an application of global game theory in which heterogeneous investors act strategically. The model allows us to explore the impact of the introduction of a rating agency on financial markets. Our model suggests that the addition of the rating agency affects the probability of default and the magnitude of the response of capital flows to changes in fundamentals in a non–trivial way, and that introducing a rating agency can bring multiple equilibria to a market that otherwise would have the unique equilibrium.

JEL Classification: F34, G14, G15

Keywords: Credit rating, Rating agency, Sovereign debt, Global game