Friday, May 5, 2017

Sharpe ratio not much help in the sandbox

Sharpe ratio = (Mean portfolio return − Risk-free rate)/Standard deviation of portfolio return
Sharpe Ratio
The Sharpe ratio has become the most widely used method for calculating risk-adjusted return; however, it can be inaccurate when applied to portfolios or assets that do not have a normal distribution of expected returns. Many assets have a high degree of kurtosis ('fat tails') or negative skewness

Sharpe Ratio

How did we get a risk free rate in the Sharpe ratio?

They mean the ten year bond purchased at the time and held to maturity, I presume.  The kurtosis is because not all terms are available in the market. In other words, not a complete bandwidth match and the system is always in motion, it is not a centered bell shape. 
The second problem is the safe rate is computed by the same folks composing their portfolios. This is easy to handle, compute the uncertainty inherent in a round robin access auto pricing pit, and subtract off that risk from average returns.  In other words, we pay a small uncertainty price for computing averages in a fair traded pit.  In time units, the fair trading uncertainty can be proxied by a time shift which the average always pays,an implied interest charge along the route. No way around,the problem, the comparison alone implies trade flow which is priced.

The sandbox drops time for asynchronous, auto priced trades. No such thing as a two color risk free rate, it is all double sided options pricing. In he smart layer we can certainyl keep an ongoing Sharpe ratio calculation, accurate ex post.

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