Limited participation under ambiguity of correlation

In this paper, we investigate the implications of correlation ambiguity for investor behaviors and asset prices. In our model, individuals' decision making incorporates both risk and ambiguity, and we demonstrate that limited participation arises from the rational decision by naïve investors to avoid correlation ambiguity. In equilibrium, the asset with lower quality generates positive excess returns. Comparative static analysis of the equilibrium result suggests that changes in the fraction of naïve investors and ambiguity level can alter equilibrium types and flight to quality phenomenon is observed. However, their impacts on asset prices are non-monotonic.