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Accelerated Investment and Credit Risk under a Low Interest Rate Environment: A Real Options Approach

Author

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  • Tetsuya Yamada

    (Bank of Japan (E-mail: tetsuya.yamada@boj.or.jp))

Abstract
Empirical studies have found that a low interest rate environment accelerates firms' investment and debt financing, leading to subsequent balance-sheet problems in many countries in recent years. We examine the mechanism whereby firms' debt financing and investment become more accelerated and the credit risk rises under a low interest rate environment from the perspective of a real options model. We find that firms tend to increase debt financing and investment not only under strong expectations of continued low interest rates but also when there are expectations of future interest rate increases, and such behavior causes higher credit risk. We also find that when future interest rate rises are expected, the investment decisions vary depending on how firms incorporate the possibility of future interest rises. Specifically, myopic firms make "last-minute investments" based on concerns over future interest rate hikes, and this behavior increases their credit risk. In contrast, economically rational firms choose to decrease their investments, carefully considering the likelihood of future interest rate hikes.

Suggested Citation

  • Tetsuya Yamada, 2010. "Accelerated Investment and Credit Risk under a Low Interest Rate Environment: A Real Options Approach," Monetary and Economic Studies, Institute for Monetary and Economic Studies, Bank of Japan, vol. 28, pages 181-214, November.
    • Handle: RePEc:ime:imemes:v:28:y:2010:p:181-214
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    References listed on IDEAS

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    More about this item

    Keywords

    Low interest rate environment; Investment behavior; Credit risk; Real options model; Corporate finance; Time-inconsistent discount rate; Behavioral economics;
    All these keywords.

    JEL classification:

    • D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty
    • D92 - Microeconomics - - Micro-Based Behavioral Economics - - - Intertemporal Firm Choice, Investment, Capacity, and Financing
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill
    • G33 - Financial Economics - - Corporate Finance and Governance - - - Bankruptcy; Liquidation

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