Bubbles with Fraud in Asset Markets

Abstract

We develop a general equilibrium asset pricing model in which assets can be counterfeited at a cost, and traders can screen for fraudulent assets, also at a cost. Fraud arises as an equilibrium outcome when both faking and screening costs are sufficiently low. When fraud exists as a latent threat without materializing, it depresses asset prices by reducing liquidity. However, when fraud is realized, it adds an additional layer to asset prices, driving them above the level observed in the absence of fraud incentives. When fraud is prevalent in the market, a sufficiently large increase in faking costs eliminates fraudulent activity, whereas a marginal increase may instead trigger market collapse.

Keywords: Counterfeiting, Screening, Bubbles, Market Collapse, Search