Sharpe Ratio

The Sharpe ratio measures the excess return of an investment per unit of risk (volatility). It is the most widely used risk-adjusted performance metric in portfolio management.

Sharpe Ratio = (Return - Risk-Free Rate) / Standard Deviation of Return

A Sharpe ratio of 1.0 means the investment earned 1 unit of excess return for each unit of volatility. Higher is better.

In fixed-income contexts, Sharpe ratios are used to:

• Compare maturities: which sector of the curve delivers the best return per unit of interest rate risk
• Evaluate strategies: the Salomon Brothers yield curve primer (Part 3) shows that the Sharpe ratio of rolling 1-month strategies varies significantly across the maturity spectrum
• Assess regime performance: the blog post "Asset Returns During Various Yield Curve Regimes" computes Sharpe ratios for bond ETFs across bull/bear steep/flat regimes

Typical Sharpe ratios for Treasury sectors:

• Short-term bills: high Sharpe (low vol, modest return)
• Intermediate notes (2-5Y): often the best Sharpe on the curve due to favorable carry-to-risk tradeoff
• Long bonds (20-30Y): lower Sharpe due to high duration volatility

The Sharpe ratio has limitations — it penalizes upside volatility equally with downside, doesn't account for non-normal return distributions, and depends heavily on the measurement period. The Sortino ratio (which only penalizes downside deviation) is sometimes preferred.