Corporate Fraud Risk and Stock Market Performance

Abstract

We investigate the impact of fraud risk - measured by the probability for earnings overstatements - on a firm's future stock market performance. Based on an out-of-sample estimation of individual firms' fraud risk, we find that stocks with higher fraud risk earn significantly lower stock market returns. A long-short trading strategy delivers a statistically significant alpha of more than 10% per year. This result is robust to controlling for differences in firms' liquidity, downside risk, or investor preferences. Furthermore, abnormal returns are higher after periods of high sentiment, suggesting that the return patterns documented here constitute an anomaly.

Keywords: Corporate Fraud, Earnings Overstatements, Stock Returns

JEL Classification: G14, G12, G320, G340