Application of risk-free rate in sharpe ratio over long time periods
Application of risk-free rate in sharpe ratio over long time periods
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knonothin · External communityPost link
External question — Quantitative Finance Stack Exchange
Author: knonothin
Original post: https://quant.stackexchange.com/questions/85772
License: CC BY-SA 4.0 — https://creativecommons.org/licenses/by-sa/4.0/
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I am working on a project that includes risk/return characteristics for a certain strategy and its benchmark (SPX). Included on the outputs is a sensitivity table, which may be showing signs of overfitting.
I tested sharpe ratio with varying risk-free rates, and while the table does show a worse sharpe for higher rates, to be expected, it also shows a worse sharpe for lower rates which I don't believe makes sense.
I am currently calculating a daily risk-free rate (effective fed funds% + 1)^(1/252)-1, then finding the spread (daily return - daily rf), taking the average of that spread, and dividing by standard deviation of returns, * sqrt(252)
While originally I thought this was a strategy specific issue, I am getting the same result of a lower sharpe on the SP500 using a lower risk free rate.
Is there a better way to calculate rf rates and/or sharpe over long time periods?
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Russlan Ramdowar · External communityPost link
External answer — Quantitative Finance Stack Exchange
Author: Russlan Ramdowar
Original post: https://quant.stackexchange.com/a/85773
License: CC BY-SA 4.0 — https://creativecommons.org/licenses/by-sa/4.0/
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One quick check: when you say “effective fed funds %,” are you plugging 5.33 or 0.0533 into the formula? And does the sensitivity table keep exactly the same return dates and observations in every case? With the returns and denominator fixed, lowering the risk-free rate cannot lower the Sharpe ratio. A non-aligned result usually means a scaling, date-alignment, missing-data issue, or another input is changing.
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