For “choice under uncertainty”, the twin assumptions of rationality and market efficiency lead to modern portfolio theory and the Capital asset pricing model (CAPM) — an equilibrium-based result — and to the Black–Scholes–Merton theory (BSM; often, simply Black-Scholes) for option pricing — an arbitrage-free result.
Is a financial market efficient? What does the “efficient” mean?
The assumption of market efficiency is associated with the notion of the unpredictability of financial markets.
If financial markets are efficient, then the markets are unpredictable.
Mainstream finance theory has traditionally held that - markets must be unpredictable, because if markets were predictable they could not be efficient and returns in excess of market returns could be made without taking additional risk. Markets embed a risk-return trade-off in which investors demand, and markets supply, excess expected returns for taking risk. In efficient market, there holds 'absence of arbitrage' - that is, one cannot make a sure profit with no investment (There is no free lunch). Thus, markets cannot be beaten. Although excess returns might indeed be achieved, they are considered to be, on average, proportional to risk.
Although financial theory states that investors cannot beat the market without risk, it does admit that an investor can beat the market, on average, by taking risk beyond the risk inherent in the market benchmark. Taking this additional risk means, of course, that the investor will suffer periods of underperformance as well as periods of superior performance relative to the market benchmark. In practice, the market downturn after 20000 forced asset management firms to evaluate that the trade-off between risk and return is dynamic and does not exclude the possibility that asset returns are, to some extent, forecastable. How can we attempt to capture the limited forecastability in financial markets?