Question 5 in the Practice Problems asks in Part A to calculate risk premia using the Singer-Terhaar approach. So far so good.
Part B asks to jugde the relative attractiveness. The solution confused me stating that the highest expected return (here for Health Care) doesn´t mean it is the most attractive sector but only compensation for systematic risk.
I used in the answer the calculated risk premia for each of the three sectors and the given standard deviation to calculate the corresponding Sharpe Ratio…! Wasn´t that a possible answer?? Answers appreciated!!
Cause that’s not there actual return. It’s more like there systematic return. You aren’t given there actual return what you got was kinda the treynor ratio. stdevA*correl/StdevM = Beta. RM/Beta = treynor. They might have idosynratic returns/alpha and idosynratic risk that wasn’t shown in the question. Trick question somewhat.
The Sharpe ratio will show you a form of the best risk adjusted return. It doesnt actually talk about value, which would involve the price of the security relative to some economic variable. (Dividend Yield, P/E, etc).
You could very well have an overvalued growth stock with a better historical sharpe ratio than an undervalued stock.
to calculate the risk premia, we have to determine the Sharpe Ratio of the Market, which must be done with the given risk premium of the market, divided by the market´s standard deviation.
Hence, I used that equation also for ranking the sectors by Sharpe Ratio…
It isn’t a true Sharpe ratio… Look at the component, it’s a Treynor disguise as a Sharpe. Dividend yield, P/E are all baked into the return, so that’s kinda irrelavant. Singer-Terhaar is all about systematic risk. It’s just the systematic risk of a foreign investment explain by the global market + unexplain systematic risk of foreign investment using it’s own stdev as an approximation. Shapre ratio uses total return not just systematic return. Like I said there is nothing in that question that talks about total return (beta + alpha). Directly from answer [However, that return is a compensation for systematic risk]. Only reason we wouldn’t use the sharpe is because of alternative investment with special stdev or return characteristics. Since the sectors listed is common equities, Sharpe ratio is appropriate. However as I have been arguing we only have systematic return and not total return.