What aspect does the Sharpe ratio measure?

The Sharpe ratio is a crucial metric in finance that measures the risk-adjusted return of an investment portfolio. It quantifies how much excess return an investor receives for the extra volatility that they endure for holding a riskier asset compared to a risk-free asset. The formula for the Sharpe ratio is the difference between the portfolio return and the risk-free rate of return, divided by the standard deviation of the portfolio's excess returns.

By using the Sharpe ratio, investors can evaluate the effectiveness of their investment strategy, allowing them to make more informed decisions on where to allocate their resources. A higher Sharpe ratio indicates that the portfolio is offering a better return per unit of risk, making it a preferred choice for many investors looking to maximize returns while controlling for risk.

This focus on the relationship between return and risk is what distinguishes the Sharpe ratio from other metrics, such as total return or volatility alone, which do not account for the risk taken to achieve a given level of return. Similarly, duration measures the sensitivity of a bond's price to interest rate changes, which is not relevant to the Sharpe ratio.