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a. Weak form level of efficiency
This level states that share prices fully reflect information in historic share price movement and patterns
(past information/historic information). If this hypothesis is correct, then, it should be possible to predict
future share price movement from historical patterns. E.g. If the company’s shares have increased steadily
over the past few months to the current price of Shs.30, then this price will already fully reflect the
information about the company’s growth and therefore the next change in share prices could either be
upward, downward or constant with equal probability. It therefore follows that technical analysis or
Chartism will not enable investors to make arbitrage profits. In markets that have achieved this level then
security prices follow a trendles random walk.
Studies to test this level have been based on the principle that:
• The share price changes are random
• That there is no connection between share price movement and new share price changes. It is
possible to prove statistically that there is no correlation between successive changes in price of shares
and therefore trend in share price changes cannot be detected. This can be done by using serial
correlation (or auto-correlation) test such as Durbin Watson Statistics.
b) Semi-Strong form level of Efficiency
This level states that share prices reflects all available public information. (past and present information).
If the market has achieved this level, then fundamental analysis will not enable investors to earn
consistently higher than average returns. Fundamental analysis involves the study of company’s accounts
to determine its theoretical value and thereby find any undervalued share. Fundamental theory states that
every share in the market has an intrinsic value, which is equal to the present value of cash flows expected
from the security.
Tests to prove semi-strong form of efficiency have concentrated on the ability of the market to anticipate
share price changes before new information is formally announced. These tests are referred to as Event
Studies. E.g. if two companies plans to merge, share prices of the 2 companies will change once the
merger plans are made public. The market would show semi-strong form of efficiency if it were able to
anticipate such changes so that share prices of the company would change in advance of the merger plans
being confirmed. Other events that can affect share prices are:
a) Stock splits
b) Death of CEO of company
c) Investment in major profitable projects
d) Changes in dividend policy, etc
c) Strong form level of Efficiency
This level states that price reflects all the available public and private information (past, present and future
information). If the hypothesis is correct, then, the mere publication of information that was previously
confidential should not have impact on share prices. This implies that insider trading is impossible. It
follows therefore, that in order to maximize shareholders’ wealth, managers should concentrate on
maximizing the NPV of each investment.
Tests that have been carried out on this level have concentrated on activities of fund managers and
individual investors. If the markets have reached the strong form levels, then fund managers cannot
consistently perform better than individual investors in the market.
Kavungya answered the question on April 13, 2021 at 07:12
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