Question 6

Wednesday, June 05, 2013 1:39 PM

The following table shows several measures related to five different assets estimated from the past 3 years data. The risk free return is 6%.

(a) Rank the assets based on their Sharpe and Sortino Ratios (use risk free return rate as target return) (3 marks) (b) Identify assets for which Sharpe ratio is not appropriate measure. (2 points) Solution:

The Sharpe ratio is given by:

the ratio of mean return in excess of the risk-free rate of return to the standard deviation of return.

So, Sharpe ratio for Asset 1: (12 - 6)/sqrt(6.4) = 2.371708245126284 Asset 2: (12.9 - 6)/sqrt(4.9) = 3.117102265023117 Asset 3: (7.6 - 6)/sqrt(3.6) = 0.843274042711568 Asset 4: (15.2 - 6) / sqrt(9) = 3.066666666666666 Asset 5: (3.1-6)/sqrt(4) = -1.45 A negative Sharpe ratio indicates that a risk-less asset would perform better than the security being analyzed. So as per Sharpe ratio, the rank of the assets is:

Asset 2 > Asset 4 > Asset 1 > Asset 3 > Asset 5.

Sortino ratio: The Sharpe Ratio, for example, measures the risk-efficiency of investments by using standard deviation to represent risk. A disadvantage of this approach is that this penalizes both downside and upside volatility. Given that investors dont mind (and indeed welcome) large upwards movements in price, the Sharpe Ratio may not best represent investor psychology. The Sortino Ratio, however, only penalizes downside risk, and is defined as

Assuming, the given downside risk is the standard deviation and not the variance, Sortino ratio for: Asset 1: (12 - 6)/7 = 0.8571 Asset 2: (12.9 - 6)/3.5 = 1.9714 Asset 3: (7.6 - 6)/5 = 0.32 Asset 4: (15.2 - 6) / 4.8 = 1.9167 Asset 5: (3.1-6)/3 = -0.9667 A negative Sharpe ratio indicates that a risk-less asset would perform better than the security being analyzed. So as per Sortino ratio, the rank of the assets is:

Asset 2 > Asset 4 > Asset 1 > Asset 3 > Asset 5.