Asset allocation, limited participation and flight‐to‐quality under ambiguity of correlation

Abstract

This paper investigates asset allocation decisions made by three types of traders depending upon incomplete information in market equilibrium. Limited participation phenomenon is observed in the equilibrium. Moreover, we show that traders with more information might not hold more risky assets than others who have less information. Less‐informed traders trade‐off between a diversification effect induced by risk‐averse attitude and a “flight‐to‐quality” effect by their aversion towards correlation ambiguity. In equilibrium, the magnitudes between equilibrium positions of different traders are affected by the true correlation coefficient, the upper‐bound correlation conceived by naive traders and the quality of risky assets simultaneously. In some scenarios, we observe that naive and uninformed traders “escape” from low‐quality assets to high‐quality ones.