SHARPE RATIO Meaning and
Definition
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Sharpe ratio is a financial measurement used to evaluate the risk-adjusted performance of an investment or portfolio. It was developed by Nobel laureate William F. Sharpe. The ratio indicates the potential excess return an investor can expect from an investment compared to its overall risk, considering the risk-free rate of return.
The Sharpe ratio is calculated by subtracting the risk-free rate of return from the investment's average rate of return and then dividing the result by the investment's standard deviation. This calculation helps to determine the return an investor is receiving in relation to the investment's overall volatility or riskiness. A higher Sharpe ratio implies a greater risk-adjusted performance compared to a lower ratio.
The ratio is a widely used metric in the financial industry to evaluate the attractiveness of investment opportunities and compare the performance of different portfolios or investment strategies. It enables investors to make informed decisions by considering both the expected return and the associated risk. By incorporating the risk-free rate, the Sharpe ratio helps investors assess whether the excess return justifies the level of risk taken.
However, it is important to note that the Sharpe ratio has certain limitations. It assumes that returns follow a normal distribution, which may not always be the case in reality. Additionally, the ratio does not consider other measures such as skewness or kurtosis that may affect investment performance. Therefore, it should be used as one of several tools in the investment decision-making process.
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Etymology of SHARPE RATIO
The term "Sharpe ratio" is named after William F. Sharpe, an American economist and Nobel laureate. William Sharpe introduced the ratio in 1966 as a measure of risk-adjusted return in financial investment. While the word "ratio" simply refers to the mathematical calculation, the term "Sharpe" signifies its association with Sharpe's work and contribution to the field of finance.
