Lesson 5 of 9
In a business context, Sharpe ratios can be used for:
Sharpe Ratio is a standard benchmark
Sharpe ratios are easy to calculate and can be used to compare the performance of a variety of different asset classes, or businesses. For budgeting and planning purposes, we can preset Sharpe ratio performance targets for business units based on historically observed return on risk for comparable asset classes or businesses.
Allocating Sharpe ratios
In translating a firm's target Sharpe ratio down to business units, we must be mindful of the effect of diversification. In addition to taking into account the type of business (for example, proprietary trading), it is important to take into account a business group's size. Smaller groups that have less opportunity for diversification (for example, a wheat futures trading group with three traders) should be given lower Sharpe ratio targets than larger businesses (for example, global fixed income with 50 traders).
Performance evaluation cycle
Sharpe ratio measurement can be integrated into the overall business performance evaluation cycle of goal setting, monitoring, and evaluation. Although fixed Sharpe Ratio targets are useful for planning purposes and set a clear return on risk objective, it's best to define a dynamic Sharpe ratio benchmark (for example, the Sharpe ratio of an index of hedge funds) for evaluating performance. In evaluating performance, superior return on risk should be rewarded.