Sharpe ratio
Return in excess of the risk-free rate per unit of total volatility: the slope of the line from the risk-free asset to a portfolio. It penalises upside and downside alike, so it flatters negatively skewed strategies.
Where you will meet it
Sharpe ratio appears in 11 learning outcomes on the CFA syllabus. A few of them:
- Explain what adding a risk-free asset does, and the capital allocation line
“The steepest such line, tangent to the efficient frontier, dominates every other combination: its slope is the Sharpe ratio of the tangency portfolio.”
- Set out risk measures suited to return distributions that are not normal
“Standard deviation weights upside and downside equally and therefore misdescribes such a distribution, and the Sharpe ratio inherits the problem.”
- Work out the information ratio on both an ex post and an ex ante basis, explain what it means, and contrast it with the Sharpe ratio
“The Sharpe ratio instead divides return in excess of the risk-free rate by total volatility, so it rewards total risk-taking, not skill relative to a benchmark.”
- Assess what adding a hedge fund strategy to a traditional portfolio does to that portfolio
“Portfolio variance depends on weights, volatilities and correlations, so a low-correlation strategy can cut total volatility and raise the Sharpe ratio, (portfolio return − risk-free rate) ÷ portfolio standard deviation, even with a modest return.”
See also
Risk-free asset · Risk-free rate
Practise it
Practise sharpe ratio until it is automatic: questions that explain every wrong option.
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