03. Calculating the Sharpe ratio

PRDTM2-787 AI Trading C4 L4 Vid3 Calculating The Sharpe Ratio

Understanding the Sharpe Ratio Calculation

The Sharpe Ratio measures the performance of an investment by adjusting for risk. Here’s a simplified breakdown of the process involved:

Key Components:

  • Mu: Annualized relative return from the backtest period.
  • R: Risk-free interest rate, used as a baseline for comparison.
  • Sigma: Volatility of the annualized relative return.

Process Outline:

  1. Data Collection:

    • Retrieve trading operations data via SQL queries.
    • Order data by trade times to check the track record.
    • Create a function sharpe_ratio for calculations.

  2. Calculate Capital Development:

    • Generate a table capital_development to log total capital over time.
    • Include both trading days and non-trading days.
    • Leverage pricing and position data for accurate capital values.

  3. Compute Sharpe Ratio:

    • Use time series of capital values to simulate a geometric Brownian motion.
    • Calculate mu and sigma, factoring in a 2% risk-free interest rate.

Outcome:

  • Example Sharpe Ratio = 1.4329, indicating potential for improvement but a solid foundation for algorithm refinement.

What does the Sharpe Ratio measure?
SOLUTION: The risk-adjusted return of an investment.

Which of the following would improve the Sharpe Ratio of an investment?
SOLUTION: Increasing the return while keeping the volatility constant.

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