IDEAS home Printed from https://ideas.repec.org/a/eee/finlet/v78y2025ics1544612325004167.html
   My bibliography  Save this article

A new quality factor adjusted by fraud probability

Author

Listed:
  • Chen, Ying
  • Bu, Yuqiao
  • Fang, Libing
  • Xu, Yuanchu

Abstract

Owing to potential financial fraud by companies, we propose a new quality factor that is mitigated by the probability of financial fraud. We estimate fraud probability using a bivariate probit model that allows for unobservable companies that actually committed fraud but were not detected. Our empirical results show that the fraud-mitigated quality-minus-junk (fmQMJ) portfolio earns significant average excess returns in both China and the United States. Furthermore, it outperforms the original quality factor within the quintile groups of low size and low book-to-market ratio. A series of Fama–MacBeth regressions show that fmQMJ contributes a new pricing factor to the value-investing strategy widely advocated in practice and academia.

Suggested Citation

  • Chen, Ying & Bu, Yuqiao & Fang, Libing & Xu, Yuanchu, 2025. "A new quality factor adjusted by fraud probability," Finance Research Letters, Elsevier, vol. 78(C).
    • Handle: RePEc:eee:finlet:v:78:y:2025:i:c:s1544612325004167
    DOI: 10.1016/j.frl.2025.107153
    as

    Download full text from publisher

    File URL: http://www.sciencedirect.com/science/article/pii/S1544612325004167
    Download Restriction: Full text for ScienceDirect subscribers only
    File URL: https://libkey.io/10.1016/j.frl.2025.107153?utm_source=ideas
    LibKey link: if access is restricted and if your library uses this service, LibKey will redirect you to where you can use your library subscription to access this item
    ---><---

    As the access to this document is restricted, you may want to

    for a different version of it.

    References listed on IDEAS

    as
    1. Guanhao Feng & Stefano Giglio & Dacheng Xiu, 2020. "Taming the Factor Zoo: A Test of New Factors," Journal of Finance, American Finance Association, vol. 75(3), pages 1327-1370, June.
    2. Bahram Soltani, 2014. "The Anatomy of Corporate Fraud: A Comparative Analysis of High Profile American and European Corporate Scandals," Journal of Business Ethics, Springer, vol. 120(2), pages 251-274, March.
    3. Bahram Soltani, 2014. "The Anatomy of Corporate Fraud: A Comparative Analysis of High Profile American and European Corporate Scandals," Post-Print hal-03970654, HAL.
    4. Messod D. Beneish & Charles M.C. Lee & D. Craig Nichols, 2013. "Earnings Manipulation and Expected Returns," Financial Analysts Journal, Taylor & Francis Journals, vol. 69(2), pages 57-82, March.
    5. Fama, Eugene F. & French, Kenneth R., 2015. "A five-factor asset pricing model," Journal of Financial Economics, Elsevier, vol. 116(1), pages 1-22.
    6. Lars Helge Hass & Monika Tarsalewska & Feng Zhan, 2016. "Equity Incentives and Corporate Fraud in China," Journal of Business Ethics, Springer, vol. 138(4), pages 723-742, November.
    7. Liu, Jianan & Stambaugh, Robert F. & Yuan, Yu, 2019. "Size and value in China," Journal of Financial Economics, Elsevier, vol. 134(1), pages 48-69.
    8. F. Jane Barton & Brian M. Burnett & Katherine Gunny & Brian P. Miller, 2024. "The Importance of Separating the Probability of Committing and Detecting Misstatements in the Restatement Setting," Management Science, INFORMS, vol. 70(1), pages 32-53, January.
    9. Wang, Yang & Ashton, John K. & Jaafar, Aziz, 2023. "Financial statement fraud, recidivism and punishment," Emerging Markets Review, Elsevier, vol. 56(C).
    10. Alexander Dyck & Adair Morse & Luigi Zingales, 2024. "How pervasive is corporate fraud?," Review of Accounting Studies, Springer, vol. 29(1), pages 736-769, March.
    11. Edward I. Altman, 1968. "Financial Ratios, Discriminant Analysis And The Prediction Of Corporate Bankruptcy," Journal of Finance, American Finance Association, vol. 23(4), pages 589-609, September.
    12. Chen, Jiamin & Fan, Yaoyao & Zhang, Xuezhi, 2022. "Rookie independent directors and corporate fraud in China," Finance Research Letters, Elsevier, vol. 46(PB).
    13. Ohlson, Ja, 1980. "Financial Ratios And The Probabilistic Prediction Of Bankruptcy," Journal of Accounting Research, John Wiley & Sons, Ltd., vol. 18(1), pages 109-131.
    14. Fama, Eugene F. & French, Kenneth R., 1993. "Common risk factors in the returns on stocks and bonds," Journal of Financial Economics, Elsevier, vol. 33(1), pages 3-56, February.
    15. Vikramaditya Khanna & E. Han Kim & Yao Lu, 2015. "CEO Connectedness and Corporate Fraud," Journal of Finance, American Finance Association, vol. 70(3), pages 1203-1252, June.
    Full references (including those not matched with items on IDEAS)

    Most related items

    These are the items that most often cite the same works as this one and are cited by the same works as this one.
    1. Li, Tangrong & Lin, Hui, 2021. "Credit risk and equity returns in China," International Review of Economics & Finance, Elsevier, vol. 76(C), pages 588-613.
    2. Juhani T. Linnainmaa & Michael R. Roberts, 2016. "The History of the Cross Section of Stock Returns," NBER Working Papers 22894, National Bureau of Economic Research, Inc.
    3. Lin, Qi, 2022. "Understanding idiosyncratic momentum in the Chinese stock market," Journal of International Financial Markets, Institutions and Money, Elsevier, vol. 76(C).
    4. Barinov, Alexander, 2023. "Profitability anomaly and aggregate volatility risk," Journal of Financial Markets, Elsevier, vol. 64(C).
    5. Lu, Chia-Wu & Wu, Hsueh-Ling & Su, Yu-Hsuan, 2024. "The icing on the cake: ESG effect on the quality factor portfolios," Finance Research Letters, Elsevier, vol. 70(C).
    6. Han, Han & Zhao, Xueqing & Wang, Zhibin, 2023. "The effect of stock pledge on corporate fraudulence: Evidence from China," Finance Research Letters, Elsevier, vol. 57(C).
    7. Ma, Tian & Leong, Wen Jun & Jiang, Fuwei, 2023. "A latent factor model for the Chinese stock market," International Review of Financial Analysis, Elsevier, vol. 87(C).
    8. Ang, Tze Chuan ‘Chewie’ & Lam, F.Y. Eric C. & Wei, K.C. John, 2020. "Mispricing firm-level productivity," Journal of Empirical Finance, Elsevier, vol. 58(C), pages 139-163.
    9. Wang, Baolian, 2019. "The cash conversion cycle spread," Journal of Financial Economics, Elsevier, vol. 133(2), pages 472-497.
    10. Simpson, Marc W. & Grossmann, Axel, 2024. "The resurrected size effect still sleeps in the (monetary) winter," International Review of Financial Analysis, Elsevier, vol. 92(C).
    11. Xiong, Tao & Wang, Peng, 2023. "Institutional ownership and momentum in the Chinese A-share market," Pacific-Basin Finance Journal, Elsevier, vol. 79(C).
    12. Clifford S. Asness & Andrea Frazzini & Lasse Heje Pedersen, 2019. "Quality minus junk," Review of Accounting Studies, Springer, vol. 24(1), pages 34-112, March.
    13. Hiroki, Takashi & Iwatsubo, Kentaro & Watkins, Clinton, 2022. "Does firm-level productivity predict stock returns?," Pacific-Basin Finance Journal, Elsevier, vol. 72(C).
    14. Beckmeyer, Heiner & Wiedemann, Timo, 2022. "Recovering Missing Firm Characteristics with Attention-Based Machine Learning," VfS Annual Conference 2022 (Basel): Big Data in Economics 264135, Verein für Socialpolitik / German Economic Association.
    15. Asness, Clifford & Frazzini, Andrea & Israel, Ronen & Moskowitz, Tobias J. & Pedersen, Lasse H., 2018. "Size matters, if you control your junk," Journal of Financial Economics, Elsevier, vol. 129(3), pages 479-509.
    16. Joshy Jacob & Pradeep K.P. & Jayanth R.Varma, 2022. "Performance of quality factor in Indian Equity Market," IIMA Working Papers WP 2022-11-01, Indian Institute of Management Ahmedabad, Research and Publication Department.
    17. Xin Xu & Feng Xiong & Zhe An, 2023. "Using Machine Learning to Predict Corporate Fraud: Evidence Based on the GONE Framework," Journal of Business Ethics, Springer, vol. 186(1), pages 137-158, August.
    18. Dong, Dayong & Wu, Keke & Fang, Jianchun & Gozgor, Giray & Yan, Cheng, 2022. "Investor attention factors and stock returns: Evidence from China," Journal of International Financial Markets, Institutions and Money, Elsevier, vol. 77(C).
    19. Kim, Dongcheol & Lee, Inro & Na, Haejung, 2019. "Financial distress, short sale constraints, and mispricing," Pacific-Basin Finance Journal, Elsevier, vol. 53(C), pages 94-111.
    20. Doron Avramov & Guy Kaplanski & Avanidhar Subrahmanyam, 2022. "Postfundamentals Price Drift in Capital Markets: A Regression Regularization Perspective," Management Science, INFORMS, vol. 68(10), pages 7658-7681, October.

    More about this item

    Keywords

    ;
    ;
    ;

    Statistics

    Access and download statistics

    Corrections

    All material on this site has been provided by the respective publishers and authors. You can help correct errors and omissions. When requesting a correction, please mention this item's handle: RePEc:eee:finlet:v:78:y:2025:i:c:s1544612325004167. See general information about how to correct material in RePEc.

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    If CitEc recognized a bibliographic reference but did not link an item in RePEc to it, you can help with this form .

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your RePEc Author Service profile, as there may be some citations waiting for confirmation.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: Catherine Liu (email available below). General contact details of provider: http://www.elsevier.com/locate/frl .

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.

    IDEAS is a RePEc service. RePEc uses bibliographic data supplied by the respective publishers.