Do sovereign credit rating events affect the foreign exchange market? Evidence from a treatment effect analysis

We estimate the effect of sovereign credit rating events on the foreign exchange market. Using entropy balancing-a treatment effect methodology that properly addresses the possible self-selection and endogeneity biases related to rating events-we find robust evidence that a positive (negative) sovereign credit rating event significantly increases (decreases) on average exchange rates, with a larger magnitude for negative events. This effect remains significant under flexible (but not under fixed) exchange rate regimes, and displays asymmetries related to the size of the rating event: in particular, only negative large (i.e., above one notch) rating events trigger a significant response of exchange rates. Lastly, we unveil important nonlinearities related to the initial value of the rating, suggesting a possible amplification mechanism: the impact of positive (negative) rating events is stronger in absolute value if ratings are initially high (low).