- CFA Exams
- 2021 Level I
- Study Session 2. Quantitative Methods (1)
- Reading 7. Statistical Concepts and Market Returns
- Subject 8. The Sharpe Measure of Risk-Adjusted Performance
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Subject 8. The Sharpe Measure of Risk-Adjusted Performance PDF Download
The Sharpe Measure is a more precise return-risk measure than standard deviation. It recognizes the existence of a risk-free return, a return for virtually zero standard deviation. It measures the reward to total volatility trade-off.
Interpretation: The S&P 500 earned 0.144% of excess return per unit of risk, where risk is measured by standard deviation.
It is defined as:
- rp = the mean return to a portfolio
- rf = the mean return to a risk-free asset
- (rp - rf) = the extra reward that investors receive for the added risk taken, called the excess return on portfolio p
- σp = the standard deviation of the portfolio returns
Note that the numerator of the Sharpe measure recognizes the existence of a risk-free return. Portfolios with large Sharpe ratios are preferred to those with smaller ratios because we assume that investors prefer return and dislike risk. The Sharpe ratio is also called the reward-to-variability ratio.
Example
The mean monthly return on T-bills (the risk-free rate) is 0.25%. The mean monthly return on the S&P 500 is 1.30% with a standard deviation of 7.30%. Calculate the Sharpe measure for the S&P 500 and interpret the results.
Sharpe measure = (1.30 - 0.25)/7.30 = 0.144
Interpretation: The S&P 500 earned 0.144% of excess return per unit of risk, where risk is measured by standard deviation.
Learning Outcome Statements
i. calculate and interpret the coefficient of variation and the Sharpe ratio;CFA® 2021 Level I Curriculum, , Volume 1, Reading 7
User Contributed Comments 5
| User | Comment |
|---|---|
| jehangir | Sharpes measure is more suerior to sd and measures excess return per unit of risk which is measured by standard deviation |
| loisliu88 | except when Sharpe ratio is negative, it doesn't work |
| mohsindi | How come it recognize Risk free return ? the formula deducts the Rf from rp |
| choas69 | it recognize the existence of risk free thus excluding it out of the formula to compute only the returns associated with risk, the bigger the results the more the better the assist. |
| Why the S&P 500 earned 0.144% of excess return in the example? Why not 14.4%? |
I used your notes and passed ... highly recommended!
Lauren
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