Financial Fraud and Investor Awareness

HKUST IEMS Working Papers No. 2018-52

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Zhengqing Gui, Yangguang Huang, Xiaojian Zhao

In our experiment and survey, we find that investors, especially risk-averse ones, become less likely to invest in fraudulent financial products with unrealistically high returns after receiving an eye-opening education program. This suggests that investors can be exploited by financial fraud due to their unawareness of the underlying high risks associated with high returns. We build a model in which a firm strategically chooses whether to offer a fraudulent product to naive investors. Education reduces the fraction of naive investors, which then attenuates or even eliminates the firm’s incentive to commit financial fraud. We then study the roles of price (rate-of-return) competition, information disclosure, and regulatory instruments, such as interest rate ceiling, legal punishment, and public education program, and find that none of them guarantees an improvement in investors’ welfare.

 

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