Sharpe Ratio is a financial metric used to measure the risk-adjusted return of an investment. It helps investors understand how much excess return they are earning for the additional risk taken compared to a risk-free asset.
Definition
The Sharpe Ratio is calculated as:
- Sharpe Ratio = (R_p - R_f) / σ_p
where:
- R_p – Return of the portfolio.
- R_f – Risk-free rate (e.g., U.S. Treasury rate).
- σ_p – Standard deviation of the portfolio's return (risk).
Interpretation
- Sharpe Ratio greater than 1 – Indicates a good risk-adjusted return.
- Sharpe Ratio between 0 and 1 – Suggests that returns may not be significantly better than the risk-free rate.
- Negative Sharpe Ratio – The investment underperforms compared to the risk-free rate.
Example Calculation
Suppose:
- Portfolio return (R_p) = 12%
- Risk-free rate (R_f) = 3%
- Portfolio standard deviation (σ_p) = 10%
The Sharpe Ratio is:
- (12% - 3%) / 10% = 0.9
Advantages
- Compares different investments – Helps assess performance across assets.
- Considers risk – Accounts for volatility, unlike raw returns.
- Widely used – Standard benchmark in portfolio management.
Limitations
- Assumes normal distribution – May not be accurate for highly skewed assets.
- Sensitive to inputs – Different risk-free rates or time periods can affect results.
- Does not capture downside risk separately – Unlike the Sortino Ratio.
Applications
- Portfolio optimization in asset management.
- Comparing mutual funds, hedge funds, and ETFs.
- Evaluating risk-adjusted returns in quantitative finance.
Variations
- Sortino Ratio – Focuses only on downside risk.
- Treynor Ratio – Uses beta instead of standard deviation.