Sharpe Ratio

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A Sharpe Ratio, developed by Prof. William Sharpe of Stanford University, is a risk measure that evaluates the relationship of return and volatility. It gives investors the ability to determine how much excess return a manager can produce for the increase in risk that the investor assumes.

By dividing the portfolio’s excess return (defined as the return above the risk-free rate received by US Treasury bills), by the standard deviation of the portfolio, investors can determine the additional return per unit of risk. A Sharpe ratio of 1:1 indicates that the rate of return is proportional to the risk assumed in seeking that reward.

The higher the Sharpe Ratio, the greater return per unit of risk taken..