Financial Risk Manager Part 1

Explanation

The Treynor ratio is the only portfolio performance evaluation measure among the options that is based solely on systematic risk.

Key Differences:

Treynor Ratio:

• Uses systematic risk (beta) as the denominator
• Formula: (Portfolio Return - Risk-Free Rate) / Beta
• Only considers market risk that cannot be diversified away

Sharpe Ratio:

• Uses total risk (standard deviation) as the denominator
• Formula: (Portfolio Return - Risk-Free Rate) / Standard Deviation
• Considers both systematic and unsystematic risk

Why B is Correct:

• Systematic risk (beta) measures a portfolio's sensitivity to market movements
• Treynor ratio specifically focuses on this market-related risk
• It assumes investors hold well-diversified portfolios where unsystematic risk is eliminated

Why A is Incorrect:

• Sharpe ratio uses total risk, which includes both systematic and unsystematic components
• It doesn't distinguish between diversifiable and non-diversifiable risk

Therefore, only the Treynor ratio is exclusively based on systematic risk.