Liquidity and Valuation in an Uncertain World
Cornell University - Department of Economics
Cornell University - Samuel Curtis Johnson Graduate School of Management
Johnson School Research Paper Series No. 13-08
In the current credit crisis there is little or no trade in a variety of financial assets, even though bids and asks exist for many of these assets. We develop a model in which this illiquidity arises from uncertainty, and we argue that this new form of illiquidity makes bid and ask prices unsuitable as metrics for establishing fair value for these assets. We show how the extreme uncertainty that traders currently face can be characterized by incomplete preferences over portfolios, and we use Bewley's  model of decision making under uncertainty to derive equilibrium quotes and the non-existence of trade at these quotes. Having established the origin of the quotes, and why the market freezes, we are then able to use our approach to suggest alternatives for valuing assets in illiquid markets.
Number of Pages in PDF File: 32
Keywords: liquidity, uncertainty, subprime crisis, fair value accountingworking papers series
Date posted: October 12, 2008
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