Econ Grapher

Sharpe Ratio

What is the Sharpe Ratio?
The Sharpe ratio is a measure of risk adjusted return. Originally the ratio was developed by William F Sharpe in 1966, he then called it the "reward-to-variability" ratio, prior to it picking up his namesake. The ratio is simply the return on the asset or portfolio minus the risk free rate, and divided by the standard deviation of returns of the asset or portfolio. Thus we can see why it was originally coined as the reward to variability ratio. It is a way of standardizing and comparing return above the risk free rate versus the risks taken to achieve that return. For example one portfolio could earn significant returns above the risk free rate, but it may come at the cost of significant volatility as measured by the standard deviation. This ratio is thus particularly suited for ranking, rather than as an absolute measure such as alpha.

How does it relate to Markets?
The Sharpe ratio is another good tool for analysing the risk and return tradeoff; (similarly concepts such as Beta, Jensen's Alpha, the Treynor ratio, are also good metrics in this sense). Generally speaking the higher the ratio the better, because a high ratio implies a higher return, but with less risk borne to achieve that return. Thus in ranking potential investments, or analysing the performance of portfolios and fund managers, the Sharpe ratio is a fine tool to add to the mix. Of course, with all ratios like this it pays to understand the calculation period and methodology; for example the period over which standard deviation is calculated may be quite relevant; and the risk free rate used will also be important.

Calculation
The Sharpe ratio is calculated as follows:

S = (R-Rf)/stdev 

Where:
S = Sharpe Ratio
R = Return of the asset or portfolio
Rf = Risk free rate over relevant period
stdev = Standard deviation of the returns of the asset

Sources and further reading:
Hedge Funds Consistency Index - Sharpe Ratio
Russell - Sharpe Ratio
Money Chimp - The Sharpe Ratio
Sharpe, W. (1994) The Sharpe Ratio. Reprinted from The Journal of Portfolio Management, Fall 1994

Graph Library:
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Original Source: http://www.econgrapher.com/encyclopedia-sharperatio.html

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