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Illiquidity and Under-Valuation of Firms

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  • Douglas Gale

    (New York University)

  • Piero Gottardi

    ()
    (University Of Venice Cà 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.

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Bibliographic Info

Paper provided by Department of Economics, University of Venice "Ca' Foscari" in its series Working Papers with number 2008_36.

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Length: 37
Date of creation: 2008
Date of revision:
Handle: RePEc:ven:wpaper:2008_36

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

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  1. Kehoe, Timothy J & Levine, David K, 1993. "Debt-Constrained Asset Markets," Review of Economic Studies, Wiley Blackwell, Wiley Blackwell, vol. 60(4), pages 865-88, October.
  2. Shleifer, Andrei & Vishny, Robert W, 1992. " Liquidation Values and Debt Capacity: A Market Equilibrium Approach," Journal of Finance, American Finance Association, American Finance Association, vol. 47(4), pages 1343-66, September.
  3. Franklin Allen & Douglas Gale, 2003. "Financial Intermediaries and Markets," Center for Financial Institutions Working Papers, Wharton School Center for Financial Institutions, University of Pennsylvania 00-44, Wharton School Center for Financial Institutions, University of Pennsylvania.
  4. Douglas W. Diamond & Raghuram G. Rajan, 2003. "Liquidity Shortages and Banking Crises," NBER Working Papers 10071, National Bureau of Economic Research, Inc.
  5. Pradeep Dubey & John Geanakoplos & Martin Shubik, 2005. "Default and Punishment in General Equilibrium," Econometrica, Econometric Society, Econometric Society, vol. 73(1), pages 1-37, 01.
  6. Sanford Grossman & Oliver Hart, 1978. "A theory of competitive equilibrium in stock market economies," Special Studies Papers, Board of Governors of the Federal Reserve System (U.S.) 115, Board of Governors of the Federal Reserve System (U.S.).
  7. Douglas W. Diamond & Raghuram G. Rajan, . "A Theory of Bank Capital," CRSP working papers, Center for Research in Security Prices, Graduate School of Business, University of Chicago 363, Center for Research in Security Prices, Graduate School of Business, University of Chicago.
  8. Holmström, Bengt & Tirole, Jean, 1994. "Financial Intermediation, Loanable Funds and the Real Sector," IDEI Working Papers, Institut d'Économie Industrielle (IDEI), Toulouse 40, Institut d'Économie Industrielle (IDEI), Toulouse.
  9. Franklin Allen & Douglas Gale, 1998. "Optimal Financial Crises," Journal of Finance, American Finance Association, American Finance Association, vol. 53(4), pages 1245-1284, 08.
  10. Douglas W. Diamond & Raghuram G. Rajan, . "Liquidity Risk, Liquidity Creation and Financial Fragility: A Theory of Banking," CRSP working papers, Center for Research in Security Prices, Graduate School of Business, University of Chicago 476, Center for Research in Security Prices, Graduate School of Business, University of Chicago.
  11. Bengt Holmström, 2001. "LAPM: A Liquidity-Based Asset Pricing Model," Journal of Finance, American Finance Association, American Finance Association, vol. 56(5), pages 1837-1867, October.
  12. Hart, Oliver D, 1979. "On Shareholder Unanimity in Large Stock Market Economies," Econometrica, Econometric Society, Econometric Society, vol. 47(5), pages 1057-83, September.
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