The Sharpe ratio

Question

The Sharpe ratio

BlackTom AI · Accepted Answer

The question concerns the Sharpe ratio and what it measures. 
Option A: 'measures the systematic (market) risk' — This is not accurate. The Sharpe ratio does not isolate market risk; it relates overall risk (as captured by total standard deviation) to excess return, not specifically the systematic component (beta). 
Option B: 'measures the idiosyncratic (individual) stock risk' — This is also incorrect. Idiosyncratic risk is the portion of total risk not explained by market movements, and the Sharpe ratio doesn’t isolate this component alone; it uses total risk in the denominator. 
Option C: 'measures the marginal return for risk' — This phrasing captures the essence that the Sharpe ratio quantifies return earned per unit of risk taken, i.e., risk-adjusted return. While some sources phrase it as excess return per unit of total risk (standard deviation), describing it as the marginal return for risk communicates the same idea of reward relative to risk. 
Option D: 'measures the marginal propensity to consume' — This is a macroeconomic concept unrelated to the Sharpe ratio or investment risk–return analysis. It involves spending behavior, not portfolio performance metrics. 
Option E: 'measures risk of a portfolio' — This is too broad. While the Sharpe ratio is used for portfolios, it specifically measures risk-adjusted return, not simply “risk of a portfolio” in isolation; it requires an accompanying return figure and compares it to risk, rather than giving a pure risk measure like volatility alone.

The Sharpe ratio

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RAROC (Risk-Adjusted Return on Capital) is calculated as:

You have been provided the following annual return data about 4 shares over a sample period 2020-2024.Which security would you choose to invest funds in if your sole objective was to minimise risk per unit of return?[Fill in the blank]

The Sharpe ratio

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