Illiquidity and Under-Valuation of Firms

Piero Gottardi and Douglas Gale ()

No 751, 2009 Meeting Papers from Society for Economic Dynamics

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.

Date: 2009
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Related works:
Working Paper: Illiquidity and Under-Valuation of Firms (2009)
Working Paper: Illiquidity and Under-Valuation of Firms (2009)
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