The Importance of Sharpe Ratio in Portfolio Performance

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The Sharpe ratio is a widely used measure of risk-adjusted performance in finance. It was developed by Nobel laureate William Sharpe in 1966 and is calculated by dividing the excess return of a portfolio (i.e., the return above the risk-free rate) by its standard deviation, which measures the volatility or risk of the portfolio.

The principal reason for using the Sharpe ratio when calculating a portfolio's performance is that it provides a measure of how much return an investor is getting for each unit of risk taken. Specifically, it indicates the percentage return above or below the risk-free rate that an investor is earning for each unit of volatility or risk taken. Thus, the higher the Sharpe ratio, the better the risk-adjusted performance of the portfolio, as it implies that the portfolio is generating higher returns for the same level of risk, or lower risk for the same level of returns, compared to a benchmark or alternative portfolio.

Therefore, answer A is correct: "It indicates the percentage return above/below the risk-free rate for each unit of risk taken." Answer B is incorrect since the Sharpe ratio can be calculated over any time period, not just rolling quarterly periods. Answer C is also incorrect since a positive Sharpe ratio does not guarantee positive returns, as it only measures risk-adjusted performance, not absolute performance. Finally, answer D is partially correct but incomplete, as a higher Sharpe ratio does indicate better risk-adjusted performance, but it does not necessarily mean that the portfolio manager has added value or outperformed their benchmark or peers, as other factors such as fees and market conditions may also influence performance.