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Illiquidity and Under-Valuation of Firms

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  • Douglas Gale
  • Piero Gottardi

Abstract

We study a competitive model in which market incompleteness implies that debt-financed firms may default in some states of nature and default may lead to the sale of the firms’ assets at fire sale prices when markets are illiquid. This incompleteness is the only friction in the model and the only cost of default. The anticipation of such losses alone may distort .rms.investment decisions. We characterize the conditions under which fire sales occur in equilibrium and their consequences on firms' investment decisions. We also show that endogenous financial crises may arise in this environment, with asset prices collapsing as a result of pure self-fulfilling beliefs. Finally, we examine alternative interventions to restore the efficiency of equilibria.

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Bibliographic Info

Paper provided by European University Institute in its series Economics Working Papers with number ECO2009/38.

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Date of creation: 2009
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Handle: RePEc:eui:euiwps:eco2009/38

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Keywords: illiquid markets; default; incomplete markets; price distortions; inefficient investment;

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  1. Douglas W. Diamond & Raghuram G. Rajan, . "Liquidity Risk, Liquidity Creation and Financial Fragility: A Theory of Banking," CRSP working papers 476, Center for Research in Security Prices, Graduate School of Business, University of Chicago.
  2. Douglas W. Diamond & Raghuram G. Rajan, 2002. "Liquidity Shortages and Banking Crises," NBER Working Papers 8937, National Bureau of Economic Research, Inc.
  3. Pradeep Dubey & John Geanakoplos & Martin Shubik, 2005. "Default and Punishment in General Equilibrium," Econometrica, Econometric Society, vol. 73(1), pages 1-37, 01.
  4. Franklin Allen & Douglas Gale, 2004. "Financial Intermediaries and Markets," Econometrica, Econometric Society, vol. 72(4), pages 1023-1061, 07.
  5. Douglas W. Diamond & Raghuram G. Rajan, 1999. "A Theory of Bank Capital," NBER Working Papers 7431, National Bureau of Economic Research, Inc.
  6. Bengt Holmstrom & Jean Tirole, 1994. "Financial Intermediation, Loanable Funds and the Real Sector," Working papers 95-1, Massachusetts Institute of Technology (MIT), Department of Economics.
  7. Hart, Oliver D, 1979. "On Shareholder Unanimity in Large Stock Market Economies," Econometrica, Econometric Society, vol. 47(5), pages 1057-83, September.
  8. 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 1343-66, September.
  9. Kehoe, Timothy J & Levine, David K, 1993. "Debt-Constrained Asset Markets," Review of Economic Studies, Wiley Blackwell, vol. 60(4), pages 865-88, October.
  10. Franklin Allen & Douglas Gale, 1998. "Optimal Financial Crises," Journal of Finance, American Finance Association, vol. 53(4), pages 1245-1284, 08.
  11. Bengt Holmström, 2001. "LAPM: A Liquidity-Based Asset Pricing Model," Journal of Finance, American Finance Association, vol. 56(5), pages 1837-1867, October.
  12. 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.
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