Why do you divide the Sharpe Ratio by the standard deviation of excess returns and not just standard deviation of returns alone?

Quantopian's community platform is shutting down. Please read this post for more information and download your code.

Back to Community

Why do you divide the Sharpe Ratio by the standard deviation of excess returns and not just standard deviation of returns alone?

posted Mar 13, 2020

Finance Theory Seeking Help Statistics Lectures

I am watching the lecture on "Instability of Estimates" and my question pertains to the formula used for the Sharpe Ratio. The formula was written with the denominator as std(R_a - R_b).

I have never seen this notation where you divide by the standard deviation of the excess returns of the asset over the risk-free rate. I have only ever seen the denominator being the standard deviation of the asset alone, not the excess over the risk-free rate. Can someone explain why this is to me? This makes a big difference in the result you get from the formula. I have searched a lot on the internet but only find the formula to be what I mentioned above, dividing by the standard deviation of the asset alone.

Is this notation specific to algorithmic trading formulas?

You've successfully submitted a support ticket.

Our support team will be in touch soon.

Need help? Contact support.

The material on this website is provided for informational purposes only and does not constitute an offer to sell, a solicitation to buy, or a recommendation or endorsement for any security or strategy, nor does it constitute an offer to provide investment advisory services by Quantopian.

In addition, the material offers no opinion with respect to the suitability of any security or specific investment. No information contained herein should be regarded as a suggestion to engage in or refrain from any investment-related course of action as none of Quantopian nor any of its affiliates is undertaking to provide investment advice, act as an adviser to any plan or entity subject to the Employee Retirement Income Security Act of 1974, as amended, individual retirement account or individual retirement annuity, or give advice in a fiduciary capacity with respect to the materials presented herein. If you are an individual retirement or other investor, contact your financial advisor or other fiduciary unrelated to Quantopian about whether any given investment idea, strategy, product or service described herein may be appropriate for your circumstances. All investments involve risk, including loss of principal. Quantopian makes no guarantees as to the accuracy or completeness of the views expressed in the website. The views are subject to change, and may have become unreliable for various reasons, including changes in market conditions or economic circumstances.

About Quantopian

The material on this website is provided for informational purposes only and does not constitute an offer to sell, a solicitation to buy, or a recommendation or endorsement for any security or strategy, nor does it constitute an offer to provide investment advisory services by Quantopian.

In addition, the material offers no opinion with respect to the suitability of any security or specific investment. No information contained herein should be regarded as a suggestion to engage in or refrain from any investment-related course of action as none of Quantopian nor any of its affiliates is undertaking to provide investment advice, act as an adviser to any plan or entity subject to the Employee Retirement Income Security Act of 1974, as amended, individual retirement account or individual retirement annuity, or give advice in a fiduciary capacity with respect to the materials presented herein. If you are an individual retirement or other investor, contact your financial advisor or other fiduciary unrelated to Quantopian about whether any given investment idea, strategy, product or service described herein may be appropriate for your circumstances. All investments involve risk, including loss of principal. Quantopian makes no guarantees as to the accuracy or completeness of the views expressed in the website. The views are subject to change, and may have become unreliable for various reasons, including changes in market conditions or economic circumstances.