January 2010
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Empirical studies have found that a low interest rate environment ac-celerates 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 expecta-tions of continued low interest rates but also when there are expecta-tions 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., the participants in the Mathe-matics for Finance Workshop, the Economics Statistics Workshop, and the Japan Association of Financial Econometrics and Engineering (JAFEE) 2009 Summer Conference, as well as the staff of the Institute for Monetary and Economic Studies (IMES), the Bank of Japan (BOJ), for their useful comments. Views expressed in this paper are those of the author and do not necessarily reflect the official views of the BOJ.