Limited participation under ambiguity of correlation $ Helen Hui Huang a , Shunming Zhang b,n , Wei Zhu c a Faculty of Business Administration, University of Regina, Regina, SK, Canada S4S 0A2 b China Financial Policy Research Center, School of Finance, Renmin University of China, Beijing 100872, PR China c Department of Statistics and Actuarial Science, University of Hong Kong, Pokfulam, Hong Kong article info Article history: Received 28 October 2015 Received in revised form 7 October 2016 Accepted 20 October 2016 JEL classification: G02 G11 D80 D81 Keywords: Ambiguity aversion Correlation ambiguity General equilibrium Limited participation Flight to quality abstract In this paper, we investigate the implications of correlation ambiguity for investor be- haviors 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 equi- librium 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. & 2016 Elsevier B.V. All rights reserved. 1. Introduction Ambiguity aversion arises when individuals incorporate both risk and ambiguity in their decision making. Knight (1921) makes a distinction between known odds (risk) and unknown odds (ambiguity). Gilboa and Schmeidler (1989) and Schmeidler (1989) conduct axiomatic analyses for decision making with ambiguity aversion. So far, ambiguity has been widely applied to many kinds of asset pricing models (e.g., Chen and Epstein, 2002; Illeditsch, 2009; Epstein and Ji, 2012, 2013) and provides explanatory power for some behavioral anomalies in financial markets, such as limited participation (e.g., Cao et al., 2005; Easley and O'Hara, 2009), negative skewness in returns (Epstein and Schneider, 2008), market mi- crostructure (Easley and O’Hara, 2010), and so on. However, researchers focus more on ambiguity of mean and variance, and ignore the ambiguity of correlation, an equally important parameter of the economy. Correlation is ubiquitous in financial markets and plays a central role in portfolio choices (Markowitz, 1952; Samuelson, 1969) and asset pricing models (e.g., Contents lists available at ScienceDirect journal homepage: www.elsevier.com/locate/finmar Journal of Financial Markets http://dx.doi.org/10.1016/j.finmar.2016.10.002 1386-4181/& 2016 Elsevier B.V. All rights reserved. ☆ This work is supported by the Social Sciences and Humanities Research Council of Canada (SSHRC) Insight Development Grant (# 430-2012-0698), the National Natural Science Foundation of China (NSFC Grant Numbers: 71273271 and 71573220), the Major Basic Research Plan of Renmin University of China (Grant Number: 14XNL001), and the KPMG Research Scholar Award (Faculty of Business Administration, University of Regina). All errors are our own. n Corresponding author. E-mail addresses: helen.huang@uregina.ca (H.H. Huang), szhang@ruc.edu.cn (S. Zhang), michael_wzhu@hku.hk (W. Zhu). URL: http://sf.ruc.edu.cn/archives/5523 (S. Zhang). Journal of Financial Markets ∎ (∎∎∎∎) ∎∎∎–∎∎∎ Please cite this article as: Huang, H.H., et al., Limited participation under ambiguity of correlation. Journal of Financial Markets (2016), http://dx.doi.org/10.1016/j.finmar.2016.10.002i