The Sharpe Index allows us to calculate the risk premium of an investment fund for each unit of risk. Therefore, in theory, at any time, the investor can choose to allocate his/her money to a "risk-free" asset, or opt for an alternative investment as long as the increase in risk is well-compensated for by the extra return to get. Even if the concept of an appropriate remuneration of an investment belongs to the bigger and better explained notion of the risk/return profile of the investor, what is important to know here is that for similar products with the same level of risk, it is possible to work out a ratio (Sharpe Index) from which we can gather information regarding the capability of a fund to generate a return for each unit of risk.
This ratio is expressed as:
Risk Premium () equals the difference between the average return of the fund () and the return of an operation that is free of risk (), whereas the risk of the fund is equal to its volatility ().
The Sharpe Index gives information on how much extra return (risk premium) a fund is capable of giving for each unit of risk (volatility), and thus making it possible to compare investment funds that have the same benchmark. As a result, funds with higher Sharpe ratios have a preference over others, as they are capable of generating greater returns for each unit of risk.
Editor: Mirko IORI
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