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The Sharpe measure: This is a ratio of one’s portfolio’s excess return divided by the portfolio’s standard deviation. The portfolio’s excess return is found by subtracting the risk-free rate from the amount of the portfolio’s actual return. The risk-free rate is considered by most investors as the amount of return one receives on a 6 or 12 month Treasury bill. Because these bills are default free and since their return is nearly guaranteed, they are considered a proxy for the risk-free rate or the benchmark over which all other financial or real assets are compared.
The difference between an asset’s return and the risk-free rate is called the risk premium, or excess return. The Sharpe measure is calculated as follows.
SI = (Rt – Rf)/σf
Where,
SI = Sharpe’s Index
Rt = Average return on portfolio
Rf = Risk free return
of = Standard deviation of the portfolio return.
The Sharpe measure is found by dividing the portfolio risk premium, or the return on the portfolio minus the risk-free rate, by the standard deviation of the portfolio.
An asset’s Sharpe measure in isolation means little. It must be measured against the market’s Sharpe measure. The market Sharpe measure is calculated the same way, by dividing the market risk premium, or the return on the market minus the risk-free rate by the standard deviation of the market. If the asset’s Sharpe measure is greater than the market’s Sharpe measure, the asset has outperformed on a risk-adjusted basis.
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