The Sharpe ratio, however, is a relative measure of risk-adjusted return. This has the effect of augmenting the Sharpe ratio. This shows that the addition of a new asset can give a fillip to the overall portfolio return without adding any undue risk. If the risk-free rate is taken as 5 per cent, the new Sharpe ratio will be 2. After the addition, the portfolio return becomes 25 per cent and standard deviation remains at 10 per cent. Let’s add another asset class to the portfolio, namely a hedge fund, and tweak the portfolio allocation to 50 per cent in equity, 40 per cent in bonds and 10 per cent in the hedge fund. In this case, the Sharpe ratio will be 1.5. Let’s take the risk-free rate to be 5 per cent. For instance, let’s take a portfolio that comprises 50 per cent equity and 50 per cent bonds with a portfolio return of 20 per cent and a standard deviation of 10 per cent. Portfolio diversification with assets having low to negative correlation tends to reduce the overall portfolio risk and consequently increases the Sharpe ratio. Intuitively, it can be inferred that the Sharpe ratio of a risk-free asset is zero. In simple terms, it shows how much additional return an investor earns by taking additional risk. In order to compensate for the higher standard deviation, the fund needs to generate a higher return to maintain a higher Sharpe ratio. If two funds offer similar returns, the one with higher standard deviation will have a lower Sharpe ratio. Realised historical return is used to calculate ex-post Sharpe ratio while ex-ante Sharpe ratio employs expected return.
S (p): Standard deviation of the portfolio The formula for calculating the Sharpe ratio is /s (p) Normally, the 90-day Treasury bill rate is taken as the proxy for risk-free rate. The measure was named after William F Sharpe, a Nobel laureate and professor of finance, emeritus at Stanford University.ĭescription: Sharpe ratio is a measure of excess portfolio return over the risk-free rate relative to its standard deviation. A portfolio with a higher Sharpe ratio is considered superior relative to its peers. Definition: Sharpe ratio is the measure of risk-adjusted return of a financial portfolio.
0 kommentar(er)
