Chartered Financial Analyst (CFA) Practice Exam Level 2

What is the Sharpe Ratio used to measure?

1. Cost efficiency of an ETF

2. Market risk premium

3. Risk adjusted returns

4. Sector performance

The correct answer is: Risk adjusted returns

The Sharpe Ratio is a widely recognized metric used to measure risk-adjusted returns. It enables investors to understand how much excess return they are earning for each unit of risk taken, which is essential when comparing the performance of different investments or portfolios. The formula for the Sharpe Ratio is the difference between the return of the investment and the risk-free rate, divided by the standard deviation of the investment's excess return. A high Sharpe Ratio indicates that the investment is providing a good return for the level of risk assumed, while a low Sharpe Ratio suggests that the return may not be worth the risk taken. In the context of the given choices, focusing on risk-adjusted returns highlights the importance of considering both the return and the volatility of an investment. This contrasts with options that address specific aspects of investment analysis, like cost efficiency of an ETF or sector performance, which do not directly relate to the fundamental purpose of the Sharpe Ratio.