Financial Risk Manager Part 1

Explanation

The correct answer is C. Sharpe ratio.

Why Sharpe Ratio is Correct:

• The Sharpe ratio measures the excess return of an investment or portfolio relative to its total risk
• Total risk is measured by the standard deviation of the investment or portfolio's returns
• Calculation: (Expected Return - Risk-Free Rate) / Standard Deviation
• Provides a measure of excess return earned per unit of total risk (both systematic and unsystematic risk)
• Higher Sharpe ratio indicates better risk-adjusted performance

Why Other Options are Incorrect:

A. Jensen's alpha:

• Measures average return over and above that predicted by CAPM
• Based on portfolio's beta and average market return
• Does not specifically measure excess return per unit of total risk

B. Treynor ratio:

• Also known as reward-to-volatility ratio
• Measures returns earned in excess of risk-free investment per unit of market risk (systematic risk only)
• Does not account for total risk

D. Sortino ratio:

• Differentiates harmful volatility from total volatility
• Uses downside deviation instead of total standard deviation
• Focuses on downside or harmful volatility rather than total risk