Financial Risk Manager Part 1

Explanation

The correct answer is A.

Key Differences Between Treynor and Sharpe Measures:

Treynor Measure:

• Uses beta (β) as the risk measure
• Beta measures systematic risk (market risk)
• Formula: (Portfolio Return - Risk-Free Rate) / Beta
• Focuses on market risk only
• Appropriate for well-diversified portfolios

Sharpe Measure:

• Uses standard deviation as the risk measure
• Standard deviation measures total risk (systematic + unsystematic risk)
• Formula: (Portfolio Return - Risk-Free Rate) / Standard Deviation
• Considers total risk exposure
• Appropriate for any portfolio, especially non-diversified ones

Why Option A is Correct:

• Accurately describes that Treynor uses beta (systematic risk) while Sharpe uses standard deviation (total risk)
• This is indeed the major conceptual difference between the two measures

Why Other Options are Incorrect:

• Option B: Reverses the risk measures - Sharpe uses standard deviation, not beta
• Option C: Both measures are straightforward to calculate; ease of calculation is not the major difference

Practical Application:

• Use Treynor when comparing well-diversified portfolios
• Use Sharpe when comparing any portfolio, especially if diversification levels vary
• Both measures help evaluate risk-adjusted performance, but they use different risk perspectives