What does the Sharpe Ratio measure?

The Sharpe Ratio is a key financial metric used to assess the performance of an investment by adjusting for its risk. It specifically measures the expected excess return per unit of total risk, which is defined as the standard deviation of the investment's returns. The excess return is typically calculated as the return of the investment minus the risk-free rate. This ratio provides investors with insight into how well the return compensates them for the risk taken, making it a valuable tool for comparing different investments or portfolios.

By focusing on expected excess return per unit of total risk, the Sharpe Ratio allows investors to determine whether the potential return of an investment is worth the associated risk. A higher Sharpe Ratio indicates that an investment has a better return relative to its risk, thereby being more attractive to investors seeking to optimize their portfolios.

In contrast, the other options do not accurately reflect the focus and utility of the Sharpe Ratio. The first choice addresses total return and total risk without specifically accounting for the excess return beyond the risk-free rate. The third option relates the variability of returns to inflation, which is more relevant to considerations of real return, and the last option compares the risk-free rate to market risk, diverging from the essence of what the Sharpe Ratio quantifies