Sharpe Ratio
The Sharpe ratio measures risk-adjusted return by comparing excess returns to volatility. It shows how much return you earn per unit of risk taken. Higher Sharpe ratios indicate better risk-adjusted performance.
Understanding the Concept
• Formula: (Return - Risk-Free Rate) / Standard Deviation • Sharpe > 1 is good, > 2 is very good, > 3 is excellent • Allows comparison between strategies with different risk levels • Penalizes both upside and downside volatility equally
Real-World Example
Strategy A returns 20% with 25% volatility. Strategy B returns 12% with 8% volatility. Assuming 5% risk-free rate: A's Sharpe = 0.60, B's Sharpe = 0.88. Despite lower raw returns, Strategy B is better risk-adjusted. You'd need to lever Strategy B to match A's returns while taking less risk.
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