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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
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