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EnCorr/Portfolio Strategist Knowledge Base
Topic ID#
(Formula) Sharpe Ratio 273
Question:

How is the Sharpe Ratio calculated?

Answer:
Sharpe Ratio

This statistic is a reward to variability ratio, which offers a means of locating an optimal risky portfolio. The equation is





 

The expected return minus the risk-free rate then is the portfolio’s risk premium. When this risk premium is divided by the standard deviation, the result provides a relative gauge for portfolio comparison. Thus, given comparable portfolios, the larger the Sharpe ratio, the better off the investor is.

 

The standard deviation used in the denominator of the Sharpe Ratio, by default, is defined as the standard deviation of the series returns.  There is an option to “Use standard deviation of risk-adjusted series” for this part of the equation though.  If you check the “Use standard deviation of risk-adjusted series,” the standard deviation used in the Sharpe Ratio is that of the difference between the series returns and the risk-free series.  The default method is the one that we have used in the past for EnCorr software.  The method of using the standard deviation of the risk-adjusted returns is a method that has become increasingly popular, and is the reason why we give both options.

 

Note:  The “Use standard deviation of risk-adjusted series” option can only be used if you first select the risk-free rate as a series, not as a Constant Risk Free Rate from the Risk-Adjusted Return Measures window.

 

Also see Risk-Adjusted Return Measures for information on assigning a risk-free rate for calculation of the Sharpe Ratio.

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