Spillover Effect of Fraud Allegations and Investor Sentiment

Abstract

We examine whether a stock price spillover effect spreads through the method of listing or country of origin and whether this spillover effect changes when investor sentiment shifts. Using a sample of fraud allegations against Chinese companies that became public through reverse mergers (CRMs), we first investigate whether firms suffering from negative stock price spillover effects are those with the same method of listing or from the same country as firms that have been accused of fraud. We find that the stock price spillover effect spreads through the firm’s country of origin only after investor sentiment about Chinese companies worsens significantly, as evinced by significant declines in the stock prices of non-fraudulent Chinese companies, including both CRMs and Chinese IPOs. Second, we find that the intensity of the stock price spillover effect increases with short-selling activities. Our findings indicate that: 1) investor sentiment plays a significant role in the spillover process involving fraud allegations; and 2) the country of origin appears to be the primary while the method of listings appears to be the secondary mechanism of the negative spillover effect when both the country and RM spillover effects exist.

Keywords: Spillover Effect, Investor Sentiment, Fraud, Reverse Mergers

JEL Classification: G14, M41