Illiquidity and Under-Valuation of Firms
39 Pages Posted: 18 Nov 2008
Date Written: November, 18 2008
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: Suggested Citation