#08-34
Liquidity and Valuation in an Uncertain World
David Easley and Maureen O'Hara, 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 akes 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-xistence 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
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