The Sharpe Ratio is used to help investors calculate the risk adjusted return relative to the risk free rate of return, the formula is as follows:
where:
Let’s assume that an investor purchases a security that has a project rate of return of 7%, if the risk free rate of return is 3% and the standard deviation of the asset is 15%, what is the Sharpe Ratio of the asset?
We can calculate the Sharpe Ratio as follows:
A Sharpe Ratio of 0.266 can be interpreted as the amount of return the asset produces for each given unit of risk. In other words, for each 1% increase in standard deviation, this particular asset produces 0.26% in return. If you multiple the standard deviation of 0.15 by 0.266, the resulting product of the two numbers is 0.07, which is asset’s assumed rate of return.
Portfolio managers typically compare the Sharpe Ratios of different portfolios and assets in order to determine which portfolio or asset has a higher risk adjusted rate of return. If two portfolios have similar investment characteristics, the portfolio with the higher Sharpe Ratio should be considered over the one with the lower ratio, all else equal.
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