Risk Free Returns / Measures Flashcards
Why does risk adjusted return matter?
Investors are risk averse, and therefore given same return, they will take portfolio with less risk
To be considered a risk free asset, what two conditions must be met
1) No Default Risk
2) No reinvestment risk
What is most commonly used as a risk free asset / rate
3 Month T Bill Yield
What does the Sharpe Ratio do?
Calculates return in terms of the risk taken to generate the return.
Expected return per unit of risk.
What is the formula for the sharpe ratio?
(Rp-Rf)/Sd
What is better, a higher or lower sharpe ratio?
Higher is better - denotes that there is less volatility to withstand
More return per unit of risk
What is Jensen’s Alpha?
Measures performance against a benchmark return (CAPM)
Measures whether a portfolio generates excess return vs its expected performance
What can Jensen’s alpha be used to do?
See where a portfolio falls on the SML
can be in-line, above or below
What is the formula for Jensen’s alpha?
Rp-(Rf+B(eRm-Rf)
Rp is actual portfolio return (the rest of the expression calculates the expected CAPM return)
What ratio is similar to the Sharpe Ratio?
The Information Ratio (IR)
What is the information ratio?
Measures the return on a portfolio vs benchmark and takes into account risk taken to achieve those returns
measures the skill of a manager
What is for formula for the Information Ratio?
IR = (Ra - Rb) / (SDa - SDb) (tracking error)
Where a is portfolio and b is benchmark
What is active share?
measures similarity between fund and benchmark
What does an active share of 0% show?
Identical to benchmark (e.g. fund is a tracker)
What does an active share of 100% show?
No holdings in common between fund and benchmark
Why is active share useful?
1) Can identify if a manager is benchmark hugging and charging too much
2) Can identify how accurately a tracker is tracking
What is the Treynor Ratio?
Measures how much excess return is generated for each point of risk taken
What is the Treynor Ratio sometimes known as?
Reward to Volatility ratio
What is the formula for the Treynor Ratio
TA = (Ra - Rf) / Ba
Where a is the portfolio / fund
What is the Sortino Ratio
A variation on the Sharpe ratio - that only accounts for downside volatility
as upside volatility is a benefit to an investor
Give 4 reasons why tracking error is unlikely to ever be 0
assuming a full duplication approach
1) Transaction Costs
2) Timing when stocks enter / leave index
3) Round-lot purchases (can only be bought in 100s = slight mismatch)
4) Restrictions on foreign ownership
Pros / Uses of Sharpe ratio?
1) Easy to communicate
2) Easy for clients to understand
3) Suitable for portfolios that aren’t fully diversified
Use of Treynor Ratio?
1) Measuring returns across different sectors
2) Clients with multiple portfolios
3) clients with diversified holdings (no idiosyncratic risk)
Pros of Treynor Ratio
1) Simple to calculate
2) Focus on systematic risk makes it useful for diversified portfolios
Cons of Treynor Ratio?
1) Limited use for non-diversified portfolio
2) Linked to capital market theory and SML
Pros of Jensen’s Alpha
1) Can be adapted to multi-factor models
2) Most rigourous risk-adjusted return
Cons of Jensen’s Alpha
1) Difficult to calculate (requires regression)
2) Relies on CAPM assumptions
Pros of Information Ratio
1) Direct comparison to benchmark
2) Simple to calculate / explain
3) allows a manager’s consistency to be measured
Cons of Information Ratio
1) Can be difficult to interpret
2) Assumes portfolio and benchmark have similar levels of systematic risk
