Thursday, December 23, 2010

Sharpe Ratio

The Sharpe Ratio was developed by Nobel Laureate William F. Sharpe, the ratio is designed to measure risk adjusted performance. Basically it is calculated by subtracting a relevant risk free interest rate from the portfolio return, and dividing that excess return amount by the portfolio standard deviation. So in essence the Sharpe ratio tells you how much excess return was generated for each unit of risk. A higher Sharpe ratio can come from either higher excess returns and/or lower risk incurred. So it is a useful metric for assessing returns relative to risk. It is also a metric that is well suited to ranking, however one shortcoming is that it is based on historical information, so there is an assumption that historical experience will continue, which may or may not be accurate.

Synonyms: Sortino ratio, Excess return to volatility ratio

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