Chartered Financial Analyst (CFA) Practice Exam Level 2

In the context of the Sharpe Ratio, what does 'Sp' represent?

1. Active risk

2. Standard deviation of returns

3. Excess return

4. Market return

The correct answer is: Standard deviation of returns

In the context of the Sharpe Ratio, 'Sp' refers to the standard deviation of the excess returns of an investment portfolio. The Sharpe Ratio is a measure used to assess the risk-adjusted return of an investment by comparing its excess return (the return above a risk-free rate) to its risk, which is quantified by the standard deviation of those excess returns. The formula for the Sharpe Ratio is expressed as: \[ \text{Sharpe Ratio} = \frac{R_p - R_f}{S_p} \] where \( R_p \) is the return of the portfolio, \( R_f \) is the risk-free rate, and \( S_p \) denotes the standard deviation of the excess returns. By focusing on the standard deviation of excess returns, the Sharpe Ratio allows investors to understand how much risk they are taking for the return they are achieving. A higher Sharpe Ratio indicates that an investor is receiving more return per unit of risk, making it a valuable tool for comparing different investments. Understanding 'Sp' as the standard deviation helps clarify its role in evaluating investment performance and the relative risks involved.