Economics Risk And Return Questions Medium
The Sharpe ratio is calculated by subtracting the risk-free rate of return from the expected portfolio return and dividing the result by the standard deviation of the portfolio's return. Mathematically, it can be expressed as:
Sharpe Ratio = (Expected Portfolio Return - Risk-Free Rate) / Standard Deviation of Portfolio Return
The risk-free rate is typically the return on a risk-free investment, such as government bonds, which is considered to have no risk. The expected portfolio return is the anticipated return on the investment portfolio, taking into account the potential gains and losses. The standard deviation measures the volatility or variability of the portfolio's returns, indicating the level of risk involved.
The Sharpe ratio is a measure of risk-adjusted return, as it considers both the expected return and the risk associated with it. A higher Sharpe ratio indicates a better risk-adjusted return, as it implies that the portfolio is generating higher returns relative to the risk taken. Conversely, a lower Sharpe ratio suggests a lower risk-adjusted return.