Liquidity and Valuation in an Uncertain World

32 Pages Posted: 12 Oct 2008

See all articles by David Easley

David Easley

Cornell University - Department of Economics; Cornell University - Department of Information Science

Maureen O'Hara

Cornell University - Samuel Curtis Johnson Graduate School of Management

Date Written: September 2008

Abstract

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 [2002] 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.

Keywords: liquidity, uncertainty, subprime crisis, fair value accounting

Suggested Citation

Easley, David and O'Hara, Maureen, Liquidity and Valuation in an Uncertain World (September 2008). Johnson School Research Paper Series No. 13-08, Available at SSRN: https://ssrn.com/abstract=1282106 or http://dx.doi.org/10.2139/ssrn.1282106

David Easley (Contact Author)

Cornell University - Department of Economics ( email )

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Cornell University - Department of Information Science ( email )

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Maureen O'Hara

Cornell University - Samuel Curtis Johnson Graduate School of Management ( email )

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United States
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