Economics Risk And Return Questions Medium
The risk-adjusted return on investment capital is calculated by dividing the excess return of an investment by its risk. This can be done using various methods, but one commonly used measure is the Sharpe ratio.
The Sharpe ratio is calculated by subtracting the risk-free rate of return from the average return of the investment, and then dividing the result by the standard deviation of the investment's returns. The formula for the Sharpe ratio is as follows:
Sharpe Ratio = (Average Return - Risk-Free Rate) / Standard Deviation
The risk-free rate is typically the return on a risk-free investment, such as a government bond. The standard deviation measures the volatility or variability of the investment's returns.
A higher Sharpe ratio indicates a better risk-adjusted return, as it means the investment is generating higher returns relative to its risk. Conversely, a lower Sharpe ratio suggests a lower risk-adjusted return.
It is important to note that the risk-adjusted return on investment capital is just one measure of evaluating the performance of an investment. Other factors such as the investment's liquidity, diversification, and correlation with other assets should also be considered when assessing risk and return.