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Accelerated Investment and Credit Risk under a Low Interest Rate Environment: A real options approach

by Tetsuya Yamada of the Bank of Japan

June 2010

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 firm's 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.

JEL Classification: G21, G32, G33, D81, D92.

Keywords: Low interest rate environment, Investment behavior, Credit risk, Real options model, Corporate finance, Time-inconsistent discount rate, Behavioral economics.

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