Illiquidity and Under-Valuation of Firms

43 Pages Posted: 27 Jan 2010

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: December 2009

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 firms’ 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.

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

JEL Classification: D50, D80, G10, G33

Suggested Citation

Gale, Douglas M. and Gottardi, Piero, Illiquidity and Under-Valuation of Firms (December 2009). CESifo Working Paper Series No. 2900. Available at SSRN: https://ssrn.com/abstract=1536451

Douglas M. Gale

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

269 Mercer Street, 7th Floor
New York, NY 10011
United States
(212) 998-8944 (Phone)
(212) 995-3932 (Fax)

Piero Gottardi (Contact Author)

European University Institute - Department of Economics ( email )

Villa Schifanoia
133 via Bocaccio
Firenze (Florence), Tuscany 50014
Italy

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

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Venice, 30121
Italy
+39 041 257 4192 (Phone)
+39 041 257 4176 (Fax)

CESifo (Center for Economic Studies and Ifo Institute)

Poschinger Str. 5
Munich, DE-81679
Germany

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