Sharpe Ratio = Excess return / risk = [R p - RFR] / σ p
Where:
- R p is the expected return on the portfolio
- RFR is the risk free rate
- σ p is the standard deviation of the portfolio
Safety First Ratio = [R p - R min] / σ p
Where R min is the minimum required rate of return (constant cor comparison across securities).
Note that both of these measures have units of return (as a percentage) over standard deviation. Also note that Sharpe Ratio will always be higher than Safety First-Ratio for any given individual security (it doesn't make sense to get a return less than the risk free rate).
If you hold R min constant across all securities and Sharpe is always greater than Safety first, the security with the highest Sharpe ratio will always have a highest Safety First as well for any and all R min.
The highest Safety first, however, does not necessarily imply the highest Sharpe (depending on the R min). In this case, it is better to chose the one with the highest R p. Example:
Two Portfolios
RFR = 1%
R min = 4%
Portfolio A
E(R) = 10
σ = 6
Sharpe = [10% - 1%] / 6 = 1.5
Safety First = [10% - 4%] / 6 = 1
Portfolio B
E(R) = 6
σ = 2
Sharpe = [6% - 1%] / 2 = 2.5
Safety First = [6% - 4%] / 2 = 1
In this case, the two securities have the same Safety First Ratio, but security B has a higher Sharpe Ratio.
3 comments:
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So We choose portfolio A since it have a highest Rp? However portfolio have a higher Sharpe Ratio, which make more financial sense to choose Portfolio B
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