Question

Explain how the Sharpe Ratio is used to manage risk. Describe the significance of US equity risk premiums as a method of comparison with other countries.

Answer 1

Typically the Sharpe ratio is the standard return earned in excessive of the risk-free rate per unit of movements or total risk. Subtracting the risk-free rate from the mean return, the performance associated with risk-taking activities can be separated. One intuition of this calculation is that a portfolio engaging in “zero risk” investment, including the purchase of U. S. Treasury bills which would essentially have the Sharpe ratio of exactly zero. Generally, the more the value of the Sharpe ratio, the more attractive the risk-adjusted return.

Equity risk premium is actually nothing but the extra or additional return that an investor would actually like to have on his or her return because of investing into the riskier assets rather than risk free assets.

US equity premiums are calculated as Equity Risk Premium = earnings yield of S&P 500 – yield on 10-year US Treasury note

The significance of equity risk premium in calculation is different from the other countries since here ERP is calculated based on the earnings that is yielded on S&P 500, any thing which is over than treasury notes is erp. Here the main consideration is given to return on S&P 500, which may not be the case with other countries. And this is the significant differece.