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The Sharpe Ratio, explained

The “Sharpe Ratio” is named after William F. Sharpe.

The Sharpe Ratio is a measure used to understand the return of an investment compared to its risk. It calculates the excess return (or risk premium) per unit of deviation in an investment asset or a trading strategy, typically referred to as risk, symbolized as:

Sharpe Ratio=(Expected return−Risk-free rate)Standard deviation of return 

Here’s a breakdown of the terms:

  • Expected return: This is the return that investors anticipate they will earn from an investment.
  • Risk-free rate: This is the return on a theoretically risk-free investment over a specified time period. U.S. Treasury bills are often used as a proxy for the risk-free rate.
  • Standard deviation of return: This quantifies the variation or dispersion of a set of returns, representing the investment’s volatility.

The Sharpe Ratio helps investors understand the return of an investment compared to its risk. The ratio is the average return earned in excess of the risk-free rate per unit of volatility or total risk. A higher Sharpe Ratio is better as it means that the investment is earning more return for its level of risk.

Who was William F Sharpe?

William Forsyth Sharpe is an American economist who was born on June 16, 1934. He was one of the originators of the Capital Asset Pricing Model (CAPM), which describes the relationship between risk and expected return and is used in the pricing of risky securities. Sharpe’s work, particularly his development of the Sharpe Ratio, has had a major impact on finance and investment, providing investors with a way to quantify the return on an investment relative to its risk.

Career and Contributions:

  • Sharpe is a professor emeritus of finance at Stanford University, where he taught and conducted research on investment, portfolio theory, and related topics.
  • He is known for his work on the pricing of financial assets, and he made substantial contributions to the fields of investment and financial economics.
  • In 1990, William F. Sharpe was awarded the Nobel Memorial Prize in Economic Sciences, which he shared with Harry Markowitz and Merton Miller. Their collective work laid the groundwork for modern portfolio theory.

Awards and Honors:

  • In 1990, Sharpe was awarded the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel (commonly referred to as the Nobel Prize in Economics).
  • The Sharpe Ratio, a measure used to understand the return of an investment compared to its risk, is named in his honor.

Educational Background:

  • Sharpe studied at the University of California, Berkeley, where he earned a B.A. in Economics, and then he went on to the University of California, Los Angeles (UCLA), where he earned a Ph.D. in Economics.

William F. Sharpe’s research and theories have fundamentally changed the fields of finance and investment, helping to create the framework for modern financial economics.

 

 

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