What role do credit ratings play in financial markets?

Credit ratings are crucial in financial markets primarily because they assess borrowers' creditworthiness and influence their borrowing costs. When rating agencies evaluate an entity, such as a corporation or a government, they analyze various financial metrics, including default risk, financial stability, and historical performance. This assessment results in a credit score or rating, which helps investors gauge the risk associated with lending to or investing in that entity.

Higher credit ratings, indicating lower risk, generally correlate with lower interest rates on borrowed funds. Conversely, borrowers with poor credit ratings often face higher borrowing costs due to the increased risk perceived by lenders. This dynamic directly impacts the availability of capital in the markets and influences investment decisions made by both institutional and individual investors.

Other options do not accurately reflect the primary function of credit ratings. They do not determine stock market indices, nor do they directly regulate financial institutions or set investment strategy guidelines. Thus, the focus of credit ratings is squarely on evaluating creditworthiness and shaping the cost of borrowing.