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Sharpening Sharpe Ratios

51 Pages Posted: 23 Aug 2002  

William N. Goetzmann

Yale School of Management - International Center for Finance; National Bureau of Economic Research (NBER)

Jonathan E. Ingersoll Jr.

Yale School of Management - International Center for Finance

Matthew I. Spiegel

Yale University - Yale School of Management, International Center for Finance

Ivo Welch

University of California, Los Angeles (UCLA); National Bureau of Economic Research (NBER)

Date Written: August 2002

Abstract

It is now well known that the Sharpe ratio and other related reward-to-risk measures may be manipulated with option-like strategies. In this paper we derive the general conditions for achieving the maximum expected Sharpe ratio. We derive static rules for achieving the maximum Sharpe ratio with two or more options, as well as a continuum of derivative contracts. The optimal strategy rules for increasing the Sharpe ratio. Our results have implications for performance measurement in any setting in which managers may use derivative contracts. In a performance measurement setting, we suggest that the distribution of high Sharpe ratio managers should be compared with that of the optimal Sharpe ratio strategy. This has particular application in the hedge fund industry where use of derivatives is unconstrained and manager compensation itself induces a non-linear payoff. The shape of the optimal Sharpe ratio leads to further conjectures. Expected returns being held constant, high Sharpe ratio strategies are, by definition, strategies that generate regular modest profits punctunated by occasional crashes. Our evidence suggests that the 'peso problem' may be ubiquitous in any investment management industry that rewards high Sharpe ratio managers.

Suggested Citation

Goetzmann, William N. and Ingersoll, Jonathan E. and Spiegel, Matthew I. and Welch, Ivo, Sharpening Sharpe Ratios (August 2002). NBER Working Paper No. w9116. Available at SSRN: https://ssrn.com/abstract=325942

William N. Goetzmann (Contact Author)

Yale School of Management - International Center for Finance ( email )

165 Whitney Ave.
P.O. Box 208200
New Haven, CT 06520-8200
United States
203-432-5950 (Phone)
203-436-9252 (Fax)

HOME PAGE: http://viking.som.yale.edu

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Jonathan E. Ingersoll Jr.

Yale School of Management - International Center for Finance ( email )

135 Prospect Street
P.O. Box 208200
New Haven, CT 06520-8200
United States
203-432-5924 (Phone)
203-432-6974 (Fax)

Matthew I. Spiegel

Yale University - Yale School of Management, International Center for Finance ( email )

135 Prospect Street
P.O. Box 208200
New Haven, CT 06520-8200
United States
203-432-6017 (Phone)
203-432-8931 (Fax)

HOME PAGE: http://som.yale.edu/~spiegel

Ivo Welch

University of California, Los Angeles (UCLA) ( email )

110 Westwood Plaza
C519
Los Angeles, CA 90095-1481
United States
310-825-2508 (Phone)

HOME PAGE: http://www.ivo-welch.info

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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