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Illiquidity and Under-Valuation of Firms

Author

Listed:
  • Douglas Gale

    (New York University)

  • Piero Gottardi

    (University Of Venice C� Foscari)

Abstract

We study a competitive model in which debt-financed firms may default in some states of nature. Incomplete markets prevent firms from hedging the risk of asset firesales when markets are illiquid. This is the only friction in the model and the only cost of default. The anticipation of such losses alone may distort firms' investment decisions. We characterize the conditions under which competitive equilibria are inefficient and the form the inefficiency takes. We also show that endogenous financial crises may arise as a result of pure sunspot events. Finally, we examine alternative interventions to restore the efficiency of equilibria.

Suggested Citation

  • Douglas Gale & Piero Gottardi, 2008. "Illiquidity and Under-Valuation of Firms," Working Papers 2008_36, Department of Economics, University of Venice "Ca' Foscari".
    • Handle: RePEc:ven:wpaper:2008_36
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    References listed on IDEAS

    as
    1. Grossman, Sanford J & Hart, Oliver D, 1979. "A Theory of Competitive Equilibrium in Stock Market Economies," Econometrica, Econometric Society, vol. 47(2), pages 293-329, March.
    2. Shleifer, Andrei & Vishny, Robert W, 1992. "Liquidation Values and Debt Capacity: A Market Equilibrium Approach," Journal of Finance, American Finance Association, vol. 47(4), pages 1343-1366, September.
    3. Bengt Holmström & Jean Tirole, 2001. "LAPM: A Liquidity‐Based Asset Pricing Model," Journal of Finance, American Finance Association, vol. 56(5), pages 1837-1867, October.
    4. Pradeep Dubey & John Geanakoplos & Martin Shubik, 2005. "Default and Punishment in General Equilibrium," Econometrica, Econometric Society, vol. 73(1), pages 1-37, January.
    5. Bengt Holmstrom & Jean Tirole, 1997. "Financial Intermediation, Loanable Funds, and The Real Sector," The Quarterly Journal of Economics, President and Fellows of Harvard College, vol. 112(3), pages 663-691.
    6. Franklin Allen & Douglas Gale, 2004. "Financial Intermediaries and Markets," Econometrica, Econometric Society, vol. 72(4), pages 1023-1061, July.
    7. Douglas W. Diamond & Raghuram G. Rajan, 2005. "Liquidity Shortages and Banking Crises," Journal of Finance, American Finance Association, vol. 60(2), pages 615-647, April.
    8. Hart, Oliver D, 1979. "On Shareholder Unanimity in Large Stock Market Economies," Econometrica, Econometric Society, vol. 47(5), pages 1057-1083, September.
    9. Douglas W. Diamond & Raghuram G. Rajan, 2001. "Liquidity Risk, Liquidity Creation, and Financial Fragility: A Theory of Banking," Journal of Political Economy, University of Chicago Press, vol. 109(2), pages 287-327, April.
    10. Douglas W. Diamond & Raghuram G. Rajan, 2000. "A Theory of Bank Capital," Journal of Finance, American Finance Association, vol. 55(6), pages 2431-2465, December.
    11. Timothy J. Kehoe & David K. Levine, 1993. "Debt-Constrained Asset Markets," The Review of Economic Studies, Review of Economic Studies Ltd, vol. 60(4), pages 865-888.
    12. repec:bla:jfinan:v:53:y:1998:i:4:p:1245-1284 is not listed on IDEAS
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    More about this item

    Keywords

    illiquid markets; default; incomplete markets; price distortions; inefficient investment;
    All these keywords.

    JEL classification:

    • D5 - Microeconomics - - General Equilibrium and Disequilibrium
    • D8 - Microeconomics - - Information, Knowledge, and Uncertainty
    • G1 - Financial Economics - - General Financial Markets
    • G33 - Financial Economics - - Corporate Finance and Governance - - - Bankruptcy; Liquidation

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