Financial Risk Manager Part 1
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The Treynor measure and the Sharpe measure are both used to evaluate the performance of a portfolio by comparing the risk-adjusted returns. However, they differ in the way they measure risk. Which of the following statements accurately describes the difference between the Treynor measure and the Sharpe measure?
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TTanishq
A
The Treynor measure uses beta as the risk measure, while the Sharpe measure uses standard deviation as the risk measure.
B
The Sharpe measure uses beta as the risk measure to assess the volatility of a portfolio relative to the market, while the Treynor measure uses standard deviation to measure total risk.
C
The Treynor measure is more complex to calculate than the Sharpe measure.
D
The Sharpe measure can only be used for well-diversified portfolios, while the Treynor measure can be used for any type of portfolio.
Explanation:
Explanation
The correct answer is A.
Key Differences Between Treynor and Sharpe Measures:
Treynor Measure:
- Uses beta as the risk measure
- Beta measures the volatility of a portfolio relative to the market
- Only considers systematic risk (market risk that affects all securities)
- Systematic risk cannot be eliminated through diversification
Sharpe Measure:
- Uses standard deviation as the risk measure
- Standard deviation measures the total risk of the portfolio
- Includes both systematic and unsystematic risk
- Unsystematic risk is unique to individual securities and can be eliminated through diversification
Why Other Options Are Incorrect:
Option B: Incorrect - The Sharpe measure does NOT use beta; it uses standard deviation. The Treynor measure uses beta, not standard deviation.
Option C: Incorrect - The complexity of calculation is not a primary distinction between the two measures. Both are relatively straightforward to calculate when the required data (returns, beta, or standard deviation) are available.
Option D: Incorrect - Both measures can be used for any type of portfolio, regardless of diversification level. The Sharpe measure is particularly useful for evaluating portfolios that are not well-diversified since it considers total risk.
Practical Implications:
- Treynor Ratio is better for well-diversified portfolios where unsystematic risk has been minimized
- Sharpe Ratio is more appropriate for portfolios that may not be fully diversified, as it accounts for both systematic and unsystematic risk
- Both ratios help investors compare risk-adjusted returns across different portfolios or investment strategies
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