Sharpes Ratio Portfolio

Evaluation
 Sharpe ratio Introduction
The Sharpe ratio is almost identical to the Treynor
measure, except that the risk measure is
the standard deviation of the portfolio instead of
considering only the systematic risk, as
represented by beta.
Conceived by Bill Sharpe, this measure closely
follows his work on the capital asset pricing
model (CAPM) and by extension uses total risk to
compare portfolios to the capital market line.
 Sharpe Index
In Sharpe index, we must know three things,
(i) the portfolio return, and
(ii) the risk free rate of return and
(iii) the standard deviation of the portfolio.
(Another important point is that for the risk free
rate of return, we may use the average return )
(over the given period of time).
The standard deviation of the portfolio is
measure the systematic risk of the portfolio.
 Sharpe Ratio
The Sharpe ratio (Sharpe, 1966) computes
the risk premium of the investment portfolio
per unit of total risk of the portfolio.
The risk premium, also known as excess
return, is the return of the portfolio less the
risk-free rate of interest as measured by the
yield of a Treasury security.
Sharpe Index Formula
 Sharpes Ration Formula
The Sharpe index is computed by dividing the
risk premium of the portfolio (rp - rf) its
standard deviation or total risk.
 Sharpe Ratio
The total risk is the standard deviation of
returns of the portfolio.
The numerator captures the reward for
investing in a risky portfolio of assets in excess
of the risk-free rate of interest while the
denominator is the variability of returns of the
portfolio.
In this sense, the Sharpe measure is also
called the reward-to-variability ratio
 Sharpes Ratio discussion
The Sharpe ratio for an investment portfolio can
be compared with the same for a benchmark
portfolio such as the overall market portfolio.
Suppose that a managed portfolio earned a
return of 20 percent over a certain time period
with a standard deviation of 32 percent.
Also assume that during the same period the
Treasury bill rate was 4 percent, and the overall
stock market earned a return of 13 percent with a
standard deviation of 20 percent.
 Sharpe & Treynor Examples
Portfolio Return RFR Beta Std. Dev. Trenor Sharpe
X 15% 5% 2.50 20% 0.0400 0.5000
Y 8% 5% 0.50 14% 0.0600 0.2143
Z 6% 5% 0.35 9% 0.0286 0.1111
Market 10% 5% 1.00 11% 0.0500 0.4545

Risk vs Return
15%
X
M
Return

10% Y

5%
Z
0%
0.00 0.50 1.00 1.50 2.00 2.50
Beta

Risk vs Return X
15%
M
Return

10%
Y
5% Z

0%
0% 5% 10% 15% 20%
Std. Dev.
 Sharpes Ratio discussion
The managed portfolios risk premium is (20 percent
4 percent) = 16 percent, while its Sharpe ratio, S, is
equal to 16 percent/32 percent = 0.50.
The market portfolios excess return is (13 percent 4
percent) = 9 percent, while its S equals 9 percent/20
percent = 0.45.
Accordingly, for each unit of standard deviation, the
managed portfolio earned a risk premium of 0.50
percent, which is greater than that of the market
portfolio of 0.45 percent, suggesting that the managed
portfolio outperformed the market after adjusting for
total risk.
Example
 Sharpe Ratio - Advantage
This measure is useful when the portfolio in
question represents the entire risky
investment.