Introduction to Sharpe Ratio
A Noble Laurette in Economics, William Sharpe developed the Sharpe ratio in order to measure the real rate of return for an investment opportunity after adjusting the risk factor involved in it.
The Sharp ratio is mostly used to assess whether an investment justifies the risk or not. Specifically, it is used to compare two business opportunities after the risk is eliminated. This has become an industry standard to use the Sharpe ratio formula as a mean to cancel the risk factor while evaluating an investment opportunity.
In simple words, the Sharpe ratio tells us how good the return compensates against the risk we take.
Risk-free Rate of Return
The risk-free rate of return is considered as an investment opportunity with zero risk. This is a theoretical return rate that an investor may expect from an absolutely no risk investment over a certain period.
The real risk-free rate of return is calculated by subtracting the inflation rate from the rate of return from an asset.
Practically, the risk-free rate of return does not truly exist as every investment opportunity comes with at least a minor magnitude of risk.
The risk-free return rate is particularly used to find if you are adequately compensated for the additional risk linked with the asset.
The Sharpe ratio uses the standard deviation in the denominator as a proxy of complete portfolio risk. This assumes that the expected returns are distributed normally. Normal distribution is actually the occurrence of recurring results; like, rolling two dices for many times, will yield seven a lot of times and two and twelve would be most uncommon.
However, the financial markets show skewed data while calculating the returns amid large number of price spikes. Moreover, the standard deviation is based on an assumption that price movement in either direction would be equally risky.
Sharpe Ratio Formula
It is quite a common knowledge for the operators of financial markets to calculate the Sharpe ratio what its each component represents. The ratio shows how much of excess return can be attained for the additional volatility for the riskier assets that you hold. However, keep in mind that you need compensation for the extra risk you take for not holding the risk-free asset.
You can further better understand by looking at the formula below that tells you how the ratio works:
Sharpe ratio = Rx – Rf
Rx is average rate of return.
Rf is best possible rate of return for a risk-free asset.
StdDev(x) is the standard deviation.
Use of Sharpe Ratio in Stocks
We are going to explain how Sharpe ratio can be used in stocks. Take an example of an investor who has allocated his funds into stocks and bonds and the average yearly return Is 15%. The existing risk-free rate is assumed at 3.5% while the portfolio return is assumed at 12%. This makes the Sharpe ratio of 95.8%. This is calculated as (15% – 3.5%) / 12%.
The investor thinks that the volatility of portfolio may drop to 7% while the expected rate will lower to 11% for the next year if the hedge funds are added to the funds.
This is also assumed that risk-free rate of return will stay constant. The Sharpe ratio, in that case will rise to 107% which is calculated as (11% – 3.5%) / 7%.
Use of Sharpe Ratio in Forex
The best application of Sharpe ratio in forex is evaluation of effectiveness of a trading strategy. While comparing the forex strategies, risk-free return does not exist as zero risk does not exist in over the counter market.
In MT4, Sharpe ratio is calculated as ratio of arithmetic average profit to the standard deviation. The absence of risk-free return distorts the result as the coefficient increases.
Following is a very plain example of how Sharpe ratio can be used in forex.
- Principle capital – $200
- Duration – one week
- Return – 20% ($40)
- Volatility – 50 pips
Hence, the Sharpe ratio is 40/50 = 0.8.
The value of coefficient is not quite awesome but the strategy can still be used. However, if the yield is high with small volatility, then the strategy can be further assessed deeply. Meanwhile, if the volatility is low, it means the yield will be flat.
Consequently, we reckon that Sharpe ratio is quite popular tool for assessment of investment opportunities in the financial markets. However, the usage of Sharpe ratio is different in Forex industry as there is no risk-free return in over the counter market. Still, the tool is effective as it gives insight for usefulness of a trading strategy.