Flight to quality and portfolio diversification under ambiguity of correlation
Abstract
We argue that ambiguous correlation between asset payoffs plays an important role in the occurrence of “flight to quality”, which in some circumstances leads investors with incomplete information to portfolio under-diversification. In this paper, we consider a multi-asset economy with four types of investors who have heterogeneous beliefs on correlation coefficients, and in which ambiguity-averse traders make decisions in a maxmin expected utility framework. A unique general equilibrium presents in four scenarios according to the dispersion of asset quality. We define a measure to gauge the degree of portfolio under-diversification, with which we show that correlation ambiguity will drive less-informed investors to hold a nondiversified portfolio if the correlation coefficient is negative, while a positive correlation drives some less-informed investors to hold a fully diversified portfolio.
