Financial Risk Manager Part 1
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John Cook, a retired surgeon, has the following assets:
- A house and land worth $150,000 in total
- An undiversified securities portfolio worth $700,000
- A fleet of automobiles worth $160,000
Between the Treynor and the Sharpe measures, which measure would be of more concern to Mr. Cook?
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TTanishq
A
The Treynor measure
B
The Treynor measure for the portfolio and the Sharpe measure for the other assets
C
The Sharpe measure
D
None of the two measures
Explanation:
Explanation
The Sharpe ratio is more relevant for Mr. Cook's situation because:
Key Differences Between Sharpe and Treynor Ratios:
- Sharpe Ratio: Measures excess return per unit of total risk (systematic + unsystematic risk)
- Treynor Ratio: Measures excess return per unit of systematic risk only (beta)
Why Sharpe is More Appropriate:
-
Undiversified Portfolio: Mr. Cook's securities portfolio ($700,000) is explicitly stated as "undiversified," meaning it contains significant unsystematic risk that the Treynor ratio ignores.
-
Total Risk Assessment: As a retired surgeon, Mr. Cook would be concerned with the safety of both income and principal, regardless of whether the risk comes from systematic or unsystematic sources.
-
Asset Composition: His portfolio represents the largest portion of his assets, and its undiversified nature means total risk (captured by Sharpe) is more relevant than just systematic risk (captured by Treynor).
Why Other Options Are Incorrect:
- A (Treynor): Only considers systematic risk, which is insufficient for an undiversified portfolio
- B (Mixed approach): Inappropriate because the portfolio's undiversified nature means Treynor would give misleading results
- D (Neither): Incorrect because Sharpe ratio provides valuable risk-adjusted performance assessment
The Sharpe measure provides a more comprehensive view of risk-adjusted returns when dealing with portfolios that contain significant unsystematic risk.
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