Option Value of Cash∗

Using a dynamic model of heterogeneous beliefs where investors agree to disagree, this paper shows: (i) beliefs may diverge, which prevents pessimists from providing liquidity. This prediction is supported by the analyst target price forecasts for ten major banks during the crisis since 2007; (ii) in the case that beliefs cross (i.e., pessimists become more optimistic than the initial optimists), liquidity provision occurs but can be delayed due to the option to sell cash higher (using the troubled asset as numeraire) if the downturn worsens. Government can reduce the option value of cash by acting as buyer of last resort. ∗I thank Patrick Bolton, Martin Oehmke, Guillaume Plantin, Tano Santos, Suresh Sundaresan, Neng Wang, Wei Xiong, and seminar participants at Columbia Business School, Florida State University for helpful comments. Yang Chen provided excellent research assistance. Mathematica code to replicate the calculations in this paper can be found at http://www.columbia.edu/∼jy2167. †Address: 421 Uris Hall, 3022 Broadway, New York, NY 10027, USA. Phone: (212) 854-9140. Email: [email protected].