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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

    (Deputy Director and Economist, Institute for Monetary and Economic Studies, Bank of Japan (E-mail: tetsuya.yamada@boj.or.jp))

Abstract

Empirical studies have found that a low interest rate environment accelerates firms f investment and debt financing, leading to subsequent balance sheet problems in many countries in recent years. We examine the mechanism whereby firm fs 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 glast-minute investments h 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," IMES Discussion Paper Series 10-E-08, Institute for Monetary and Economic Studies, Bank of Japan.
  • Handle: RePEc:ime:imedps:10-e-08
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    File URL: http://www.imes.boj.or.jp/research/papers/english/10-E-08.pdf
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    References listed on IDEAS

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    1. Zhdanov, Alexei, 2007. "Competitive Equilibrium with Debt," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 42(03), pages 709-734, September.
    2. Takashi Shibata & Tetsuya Yamada, 2009. "Dynamic Model of Credit Risk in Relationship Lending: A Game- Theoretic Real Options Approach," Monetary and Economic Studies, Institute for Monetary and Economic Studies, Bank of Japan, vol. 27(1), pages 195-218, November.
    3. Suresh Sundaresan & Neng Wang, 2007. "Investment under Uncertainty with Strategic Debt Service," American Economic Review, American Economic Association, vol. 97(2), pages 256-261, May.
    4. Mella-Barral, Pierre & Perraudin, William, 1997. " Strategic Debt Service," Journal of Finance, American Finance Association, vol. 52(2), pages 531-556, June.
    5. Okina, Kunio & Shirakawa, Masaaki & Shiratsuka, Shigenori, 2001. "The Asset Price Bubble and Monetary Policy: Japan's Experience in the Late 1980s and the Lessons: Background Paper," Monetary and Economic Studies, Institute for Monetary and Economic Studies, Bank of Japan, vol. 19(S1), pages 395-450, February.
    6. Michi Nishihara & Takashi Shibata, 2009. "Investment Game with Debt Financing," World Scientific Book Chapters,in: Recent Advances In Financial Engineering, chapter 9, pages 161-187 World Scientific Publishing Co. Pte. Ltd..
    7. Hoshi, Takeo, 2001. "What Happened to Japanese Banks?," Monetary and Economic Studies, Institute for Monetary and Economic Studies, Bank of Japan, vol. 19(1), pages 1-29, February.
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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;

    JEL classification:

    • 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
    • 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

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