Question

A portfolio’s expected return is 12%, its standard deviation is 20%, and the risk-free rate is 4%. Which of the following would make for the greatest increase in the portfolio’s Sharpe ratio?

a. An increase of 1% in expected return.

b. A decrease of 1% in the risk-free rate.

c. A decrease of 1% in its standard deviation.

Short answer

Both a. and b

Step-by-step solution

Definition

The Sharpe ratio measures the performance of an investment compared to a risk free asset, after adjusting its risks. Usually a Sharpe ratio more than 1.0 is considered good for investment.

Explanation on the importance of portfolio of the risky asset

In the given scenario, an increase of 1% in expected return and a decrease of 1% in risk-free rate will have the same impact of increasing the Sharpe measure from .40 to .45. Therefore the correct answer would be optioned‘ a’ and ‘b.’