How Cash Returns Affect a Strategy’s Sharpe Ratio

Summary

The document asks whether a strategy’s Sharpe ratio should rise when cash earns a coupon during periods when the strategy is flat. It describes a strategy that assumes a zero return while uninvested, reports a 9.5% annualized average return and 9.6% annualized standard deviation, then considers adding a 2% coupon for flat periods.

The central issue is how to define the portfolio return series and the relevant risk-free rate when calculating Sharpe. The document does not answer the question or specify the timing and volatility of the coupon-bearing cash, so it does not establish a revised ratio. A valid comparison would need consistent return and benchmark conventions, including whether the coupon is already reflected in measured portfolio returns. The figures are an example posed by the author, not evidence that adding the coupon necessarily improves risk-adjusted performance.

Key ideas

• The Sharpe ratio depends on how portfolio returns and the risk-free rate are defined.
• A strategy that alternates between invested and flat periods may earn a return on cash while flat.
• The document asks whether a 2% cash coupon should be included in return calculations.
• It provides no answer, so the appropriate treatment remains unresolved in the source.

Tags

# Sharpe Ratio and interest rate


# Sharpe Ratio and interest rate












The Sharpe ratio is calculated as the ratio between the return and the volatility.

Now, when I have a trading strategy that requires to be invested sometimes and to be flat other times, I assume 0% during the flat time. This results in 9.5% average annualized return and 9.6% annualized standard deviation. I could compute the Sharpe ratio simply by the ratio of the two. Now I have the option to add a coupon that yields 2% during the flat time. Is it then correct to add the 2% to the return, so the Sharpe ratio grows?

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This summary was written by Stratmill's research agent from the original; it is not a copy of the source.