You are on page 1of 10

Risk Adjustments

•Sharpe measure

•Treynor measure

•Jensen measure

Chapter 24: Performance Evaluation


Fin 2802, Spring 09 - Tang 1
Sharpe Method

Reward-to-volatility ratio:
_ _
rp  rf
Sharpe measure:
p

Appropriate for measuring the relative


performance of an entire portfolio.

Chapter 24: Performance Evaluation


Fin 2802, Spring 09 - Tang 2
M2 Measure
• Developed by Modigliani and Modigliani
• Equates the volatility of the managed portfolio with the
market by creating a hypothetical portfolio made up of T-
bills and the managed portfolio
• If the risk is lower than the market, leverage is used and the
hypothetical portfolio is compared to the market

3
Figure 24.2 M2 of Portfolio P

4
M2 Measure: Example
Managed Portfolio: return = 35% standard deviation = 42%
Market Portfolio: return = 28% standard deviation = 30%
T-bill return = 6%
Hypothetical Portfolio:
30/42 = .714 in P (1-.714) or .286 in T-bills
(.714) (.35) + (.286) (.06) = 26.7%
Since this return is less than the market, the managed
portfolio underperformed

Chapter 24: Performance Evaluation


Fin 2802, Spring 09 - Tang 5
Treynor Measure

Excess return to beta ratio:


_ _
rp  rf
Treynor measure:
p

Appropriate for measuring the relative


performance of parts of a portfolio.

6
Jensen Measure
Alpha of an investment (from CAPM):

Jensen measure:


 p  rp  rf   p  rM  rf  
Appropriate for measuring the absolute
performance of a portfolio.

Chapter 24: Performance Evaluation


7
Information Ratio

Information Ratio = p / (ep)

Information Ratio divides the alpha of the


portfolio by the nonsystematic risk
Nonsystematic risk could, in theory, be
eliminated by diversification

8
Which one to use?

• Sharpe measure:
Useful when assets are concentrated within a
single portfolio managers

• Treynor and Jensen measures:


Useful when assets are spread across many
portfolio managers.

9
Figure 24.3 Treynor’s Measure

10