Task 20 - Hedge

1.
Identify how the Sortino ratio is different from Sharpe’s ratio, for an investor while
considering investments?
Sharpe Ratio
The Sharpe ratio popularly known as the reward-to-variability ratio is the most common
portfolio management metric. It is a measure of the risk-adjusted return of a financial portfolio.
It is a measure of an excess portfolio compared to the risk-adjusted returns. It helps to study
the risk-adjusted performance of a mutual fund. It is defined as the excess returns of the
scheme, divided by the standard deviation scheme return over a certain period. The basic
formula for the Sharpe ratio is:
Sharpe Ratio : R(p)- R (f)/ S(p)

Where,
R(p) = Portfolio return
R( f) = Risk free rate of return
S(p)= Standard deviation of the portfolio.
For instance, if two funds offer similar returns, then one with the higher standard deviation will
have a lower Sharpe ratio. To better understand its relevance of it, let’s suppose there are two
funds A and B. Where Fund A provides a return of 10% a year, while Fund B provides a return
of 8% yearly. If the risk-free interest rate (mainly considered as a government fixed deposit) is
4% and the standard deviation is 8% and 4%. Then the Sharpe ratio will be 0.75 and 1. Now,
looking at this perspective, despite Fund A having a higher return, Fund B has a better
risk-adjusted front.
Sortino Ratio:
It is basically a tool that measures the performance of the investment relative to the downward
deviation. Unlike Sharpe, this doesn’t consider the total volatility of the investment. This is
well suited for retail investors as they are more concerned about the downside risk of
investment. The Sortino ratio formula will be:
Sortino Ratio: R- R(f)/SD
Where,
R = Expected returns
R (f) = Risk-free rate of return

SD= Standard Deviation of the Negative Asset return
To better understand this, let's suppose scheme A has an annualised return of 15% and the
downside deviation of the scheme is 13%. Consider a scheme B which has generated
annualised returns of 10% and its downside deviation is 4%. Let’s assume that risk-free returns
by 7%. The Sortino ratio of scheme A will be ( 15%- 7%)/13% is equal to 0.61% and the
Sortino ratio of scheme B will be ( 10%- 7%)/13% is equal to 0.75%. Despite the fact that A
has better returns, Scheme B has a better Sortino ratio. Hence B will be a better investment
option than A.
2. How mutual fund investments can be made based on Treynor’s ratio?
In essence, the Treynor ratio is a risk-adjusted measurement of return based on systematic risk.
It indicates how much return an investment, such as a portfolio of stocks, a mutual fund, or an
exchange-traded fund, earned for the amount of risk the investment assumed.
If a portfolio has a negative beta, however, the ratio result is not meaningful. A higher ratio
result is more desirable and means that a given portfolio is likely a more suitable investment.
Since the Treynor ratio is based on historical data, however, it's important to note this does not
necessarily indicate future performance, and one ratio should not be the only factor relied upon
for investing decisions.
3. How mutual fund investments can be made based on Sharpe’s ratio?
The Sharpe ratio is often used to compare the change in overall risk-return characteristics
when a new asset or asset class is added to a portfolio. For example, an investor is considering
adding a hedge fund allocation to their existing portfolio that is currently split between stocks
and bonds and has returned 15% over the last year. The current risk-free rate is 3.5%, and the
volatility of the portfolio’s returns was 12%, which makes the Sharpe ratio of 95.8%, or (15%
- 3.5%) divided by 12%.
The investor believes that adding the hedge fund to the portfolio will lower the expected return
to 11% for the coming year, but also expects the portfolio’s volatility to drop to 7%. He or she
assumes that the risk-free rate will remain the same over the coming year. Using the same
formula, with the estimated future numbers, the investor finds the portfolio has the expected
Sharpe ratio of 107%, or (11% - 3.5%) divided by 7%.
Here, the investor has shown that although the hedge fund investment is lowering the absolute
return of the portfolio, it has improved its performance on a risk-adjusted basis. If the addition
of the new investment lowered the Sharpe ratio, it should not be added to the portfolio. This
example assumes that the Sharpe ratio based on past performance can be fairly compared to
expected future performance.
4. A bond pays 12% interest per annum. The inflation rate for that year is 4%.
Calculate the real return?
Solution
Real return = Nominal rate of return – inflation rate Nominal
rate of return – 12%
Inflation rate – 4%
Real return = 12% - 4%
= 8%
5. An investment earns a return of 16% p.a., but the income is taxable in the hands of
the investor. The investor’s marginal tax rate is 20%. Calculate his after-tax rate of
return?
Solution
Pre-tax rate of return= 16%

Tax rate applicable = 20%
Tax adjusted rate of return = 16% *(1 - .20) = 12.8%

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1.

Sharpe Ratio : R(p)- R (f)/ S(p)

R (f) = Risk-free rate of return

2. How mutual fund investments can be made based on Treynor’s ratio?

3. How mutual fund investments can be made based on Sharpe’s ratio?

Real return = 12% - 4%

Pre-tax rate of return= 16%

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