Illiquidity and Under-Valuation of Firms

39 Pages Posted: 18 Nov 2008

See all articles by Douglas M. Gale

Douglas M. Gale

New York University (NYU) - Department of Economics

Piero Gottardi

European University Institute - Department of Economics; Ca Foscari University of Venice - Dipartimento di Economia; CESifo (Center for Economic Studies and Ifo Institute)

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Date Written: November, 18 2008

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.

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

JEL Classification: D5, D8, G1, G33

Suggested Citation

Gale, Douglas M. and Gottardi, Piero, Illiquidity and Under-Valuation of Firms (November, 18 2008). University Ca' Foscari of Venice, Dept. of Economics Research Paper Series No. 36/WP/2008. Available at SSRN: https://ssrn.com/abstract=1303524 or http://dx.doi.org/10.2139/ssrn.1303524

Douglas M. Gale (Contact Author)

New York University (NYU) - Department of Economics ( email )

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Piero Gottardi

European University Institute - Department of Economics ( email )

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Italy

Ca Foscari University of Venice - Dipartimento di Economia ( email )

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Italy
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+39 041 257 4176 (Fax)

CESifo (Center for Economic Studies and Ifo Institute)

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Munich, DE-81679
Germany

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