8.42What is the Sharpe ratio?
1What is it?
The Sharpe ratio measures return earned per unit of total risk, above a risk-free rate.
2Why does it exist?
It tells you whether higher returns came from skill or simply from taking more risk.
3Calculation
Sharpe = (Fund return − Risk-free rate) ÷ Standard deviation
- Fund A: (15% − 6%) ÷ 15% = 0.6
- Fund B: (13% − 6%) ÷ 8% = 0.875
B delivers more return per unit of risk.
4Quick revision
- Return per unit of risk.
- Higher is better.
- Compare within category.
5Knowledge check
Q1. Return 12%, risk-free 6%, SD 10%. Sharpe?Show answer
0.6.
Q2. Higher or lower Sharpe is better?Show answer
Higher.
Q3. What risk does Sharpe use?Show answer
Total volatility (standard deviation).