Sharpening Sharpe Ratios

William Goetzmann, Jonathan E. Ingersoll, Jr. (), Matthew I. Spiegel () and Ivo Welch
Additional contact information
Jonathan E. Ingersoll, Jr.: Yale School of Management, International Center for Finance
Matthew I. Spiegel: Yale School of Management, International Center for Finance

Yale School of Management Working Papers from Yale School of Management

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 has a truncated right tail and a fat left tail. We also derive dynamic 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 punctuated by occasional crashes. Our evidence suggests that the

Keywords: Sharpe Ratio; Hedge Funds; Derivatives (search for similar items in EconPapers)
JEL-codes: G0 G1 G2 (search for similar items in EconPapers)
Date: 2002-02-01
New Economics Papers: this item is included in nep-dev, nep-fin and nep-rmg
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Citations: View citations in EconPapers (46)

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Working Paper: Sharpening Sharpe Ratios (2002)
Working Paper: Sharpening Sharpe Ratios (2002)
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Persistent link: https://EconPapers.repec.org/RePEc:ysm:somwrk:ysm29

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