The directors of Clear Tel Ltd, a private telecommunication company, are considering a proposed resolution for converting the company to a public company and listing its equity stock on the stock exchange. The directors expects that the stock market listing can enhance Clear Tel’s ability to raise large amounts of capital from the public. However, they fear that stock market inefficiencies could have a negative effect on the price of Clear Tel’s equity stock.
Required:
Explain the THREE degrees of stock market efficiency, and how the price of Clear Tel is expected to move in each case. (6 marks)
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The Three Basic Forms of the EMH
The efficient market hypothesis assumes that markets are efficient. However, the efficient market hypothesis (EMH) can be categorized into three basic levels:
- Weak-Form EMH
The weak-form EMH implies that the market is efficient, reflecting all market information. This hypothesis assumes that the rates of return on the market should be independent; past rates of return have no effect on future rates. In this event that the stock market has weak-form efficiency, the price of Clear Tel will move in line with historical changes. - Semi-Strong EMH
The semi-strong form EMH implies that the market is efficient, reflecting all publicly available information. This hypothesis assumes that stocks adjust quickly to absorb new information. The semi-strong form EMH also incorporates the weak-form hypothesis. Given the assumption that stock prices reflect all new available information and Clear Tel purchase stocks after this information is released, Clear Tel cannot benefit over and above the market by trading on new information. - Strong-Form EMH
The strong-form EMH implies that the market is efficient: it reflects all information both public and private, building and incorporating the weak-form EMH and the semi-strong form EMH. Given the assumption that stock prices reflect all information (public as well as private) Clear Tel would not be able to profit above the average investor even if he was given new information.