Real options and the perverse effect of interest rates on investment timing

Abstract

This paper examines the relationship between investment and interest rates within the standard model of real options. We analyse the effect of interest rates on investment through the expected time until investment. The sign of the relationship is ambiguous, and critically dependent on the choice of the state variable and the parameters taken as model primitives. If the payout rate of the project (dividend yield) is taken as a model parameter, results are robust. The main novel conclusions drawn from the analysis are the following. Firstly, we provide new conditions under which increasing the interest rate accelerates irreversible investments. In particular, a raise of the interest rate favours investment when the initial value of the state variable is far from the optimal threshold; in some cases, investment is favoured independently of the value of the state variable. Secondly, the level of volatility affects the investment/interest rate relationship; in particular, a raise of the interest rate tends to favour investment in hi‐tech sectors (the opposite conclusion holds for mature sectors). Thirdly, the analysis implications remain under costless reversibility.

Investment under uncertainty and irreversibility: Evidence from the shipping markets

“…For instance, Henzel and Rengel (2017) show that increased uncertainty of a commodity price index results in a significant reduction of real economic activity, while Triantafyllou et al (2022) provide empirical evidence that the U.S. economic activity and its components are reduced due to uncertainty shocks in agricultural, metals and energy commodity markets. Gutiérrez (2021) rely on real options analysis to show that an increase in interest rates triggers investment when the state variable is far from the optimal threshold and tends to favour investment in hi-tech sectors.…”