Corporate Fraud Risk and Stock Market Performance

44 Pages Posted: 28 Jul 2015 Last revised: 8 Jan 2016

Lena Jaroszek

Copenhagen Business School - Department of Finance

Alexandra Niessen-Ruenzi

University of Mannheim - Department of Finance

Stefan Ruenzi

University of Mannheim - Department of International Finance

Date Written: January 2016

Abstract

In this paper we investigate the impact of fraud risk -- measured by the probability for earnings overstatements -- on a firms 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 trading strategy going long in stocks of firms with low fraud risk and short in stocks of firms with high fraud risk 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. Our results suggest that the market does not efficiently price corporate fraud risk. Limits of arbitrage do not explain our results. 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

Suggested Citation

Jaroszek, Lena and Niessen-Ruenzi, Alexandra and Ruenzi, Stefan, Corporate Fraud Risk and Stock Market Performance (January 2016). Available at SSRN: https://ssrn.com/abstract=2636633 or http://dx.doi.org/10.2139/ssrn.2636633

Lena Jaroszek (Contact Author)

Copenhagen Business School - Department of Finance ( email )

Solbjerg Plads 3
Frederiksberg C, DK - 2000
Denmark

Alexandra Niessen-Ruenzi

University of Mannheim - Department of Finance ( email )

Mannheim, 68131
Germany

Stefan Ruenzi

University of Mannheim - Department of International Finance ( email )

L9, 1-2
Mannheim, 68131
Germany

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