SHARPE’S REWARD TO VARIABILITY MODEL
Initially, the performance evaluation of portfolios was done entirely by a
manager who was aware of the risk associated with the return, but they did
not know how to quantity risk, so they could not consider it explicitly.
Portfolio evaluation has evolved dramatically since the early 1960s. The
developments enabled the investors to quantify risk in terms of variability
of returns, but there was still no composite measure and both the factors
were considered separately. Sharpe, Treynor, Jensen, and others have
developed models for portfolio evaluation that take into consideration both
risk and return of the portfolio.
This article deals with evaluating portfolio performance based on Sharpe's
reward to Variability Model.
Sharpe’s Model follows closely from the author’s earlier work on CAPM.
This model yields a single value that can be used for investment
performance rankings. It assigns the highest rank portfolio that has the best
risk-adjusted rate of return; His measures measure the risk of portfolios.
The difference between a portfolio’s expected rate of return and the riskless
rate is called Risk Premium. Then each portfolio’s risk premium is
divided by its standard deviation of annual returns a measure of the
portfolio’s total risk or variability, estimated over the evaluation period. The
resulting number is the rate of reward per unit of variability.
The Sharpe ratio, or reward-to-variability ratio, is the slope of the capital
allocation line (CAL). The greater the slope (higher number) the better the
asset. Note that the risk being used is the total risk of the portfolio, not its
systematic risk which is a limitation of the measure. The portfolio with the
highest Sharpe ratio has the best performance but the Sharpe ratio by itself
is not informative. To rank portfolios, the Sharpe ratio for each portfolio
must be computed.
Sharpe’s Index is Explained in the following equation:
This index gives a measure of portfolios' total risk and variability of returns
about the risk Premium. This method ranks all portfolios based on St . If
one portfolio has a higher St than another, the first one is better performing.
Disadvantages of Sharpe ratio
However, the Sharpe ratio suffers from two limitations:
• it uses total risk (which is appropriate only if the investor has no
other assets), and
• it does not provide any information other than the ranking of
Initially, the performance evaluation of portfolios was done entirely by a
manager who was aware of the risk associated with the return, but they did
not know how to quantity risk, so they could not consider it explicitly.
Portfolio evaluation has evolved dramatically since the early 1960s. The
developments enabled the investors to quantify risk in terms of variability
of returns, but there was still no composite measure and both the factors
were considered separately. Sharpe, Treynor, Jensen, and others have
developed models for portfolio evaluation that take into consideration both
risk and return of the portfolio.
This article deals with evaluating portfolio performance based on Sharpe's
reward to Variability Model.
Sharpe’s Model follows closely from the author’s earlier work on CAPM.
This model yields a single value that can be used for investment
performance rankings. It assigns the highest rank portfolio that has the best
risk-adjusted rate of return; His measures measure the risk of portfolios.
The difference between a portfolio’s expected rate of return and the riskless
rate is called Risk Premium. Then each portfolio’s risk premium is
divided by its standard deviation of annual returns a measure of the
portfolio’s total risk or variability, estimated over the evaluation period. The
resulting number is the rate of reward per unit of variability.
The Sharpe ratio, or reward-to-variability ratio, is the slope of the capital
allocation line (CAL). The greater the slope (higher number) the better the
asset. Note that the risk being used is the total risk of the portfolio, not its
systematic risk which is a limitation of the measure. The portfolio with the
highest Sharpe ratio has the best performance but the Sharpe ratio by itself
is not informative. To rank portfolios, the Sharpe ratio for each portfolio
must be computed.
Sharpe’s Index is Explained in the following equation:
This index gives a measure of portfolios' total risk and variability of returns
about the risk Premium. This method ranks all portfolios based on St . If
one portfolio has a higher St than another, the first one is better performing.
Disadvantages of Sharpe ratio
However, the Sharpe ratio suffers from two limitations:
• it uses total risk (which is appropriate only if the investor has no
other assets), and
• it does not provide any information other than the ranking of
