See Also:
Efficient Market Theory
Effective Rate of Interest Calculation
Coupon Rate Bond
Discount Rate
Federal Funds Rate Definition
Sharpe Ratio Definition
Sharpe ratio, defined as the excess return or risk premium of a well diversified portfolio or investment per unit of risk, which is measured using standard deviation. The sharpe ratio is also known as the reward to variability ratio or the reward to volatility ratio.
Sharpe Ratio Explained
The sharpe ratio is a good measure for investors because it allows them to distinguish the amount of reward needed per unit of risk. This allows for risk averse investors to stay away from low reward high risk situation that they are uncomfortable with. The higher the sharpe ratio the better for an investor. It is also useful in establishing the sharpe ratio efficient frontier in which an investor can build a model for several different investments and build a portfolio that is exactly equal to the desired sharpe ratio. These efficient frontier models can distinguish down to the specific weights what an investor needs to do to build the desired portfolio.
Sharpe Ratio Formula
The sharpe ratio formula is as follows:
Sharpe ratio =
E(R-Rf)
σ
Where:
R = asset return
R
f = Risk free return
E(R-R
f) = Expected return of the risk premium
σ = standard diviation of the risk premium
Sharpe Ratio Example
Tim is looking to invest in a stock that has an expected return of 12%. The risk free rate is 4%, and the standard deviation of the risk premium is 10%. Thus, the sharpe ratio calculation is as follows:
Sharpe = (.12-.04)/.10 = .8
The .8 can be interepreted as meaning that for every unit of risk that you accept as an investor you will be taking on an additional one and a quarter amount of risk.