Which statement describes how the Sharpe ratio is used?

• A. It measures returns per unit of total risk.
• B. It compares risk-adjusted performance by using (portfolio return − risk-free rate) / standard deviation; higher is better.
• C. It measures downside risk only.
• D. It is the same as alpha.

Answer: (B)

The Sharpe ratio measures risk-adjusted performance by comparing how much extra return you earn for each unit of risk taken. It does this with the formula: (portfolio return − risk-free rate) divided by standard deviation. Subtracting the risk-free rate accounts for what you could earn without taking risk, and using standard deviation as the risk metric captures total volatility, including both upside and downside movements. A higher ratio means the portfolio delivers more excess return per unit of risk, which is the essence of efficient risk-taking. It isn’t about downside risk alone (that would be a different ratio, like the Sortino), and it’s not the same as alpha, which reflects returns beyond what CAPM would predict.