Abstract
The Sharpe Ratio offers an excellent summary of the excess return required per unit of risk invested. This work presents an adaptation of the ex-ante Sharpe Ratio for currencies where we consider a random walk approach for the currency behavior and implied volatility as a proxy for market expectations of future realized volatility. The outcome of the proposed measure seems to gauge some information on the expected required return attached to the “peso problem”.
Highlights
The reward to variability ratio has been around for nearly 40 years since the seminal work by Sharpe (1966)
The ratio is always stated as the excess return of a portfolio or strategy per unit of risk handled
The proposed Sharpe Ratio shows the interest rate differential return per unit of implied volatility, and do not try to make a judgement regarding the future path of the investment currency
Summary
The reward to variability ratio has been around for nearly 40 years since the seminal work by Sharpe (1966). Sharpe Ratio; peso problem; carry trade; currency strategies. Where iit∗t is the one period interest rate return for the investment currency and iitt is the investor currency or risk free currency – we may consider these two definitions as equivalent for this exercise.
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