Identifying the fair value of Sharpe ratio by an option valuation approach

Abstract

This study aims to identify a theoretical fair value of the Sharpe ratio. For this purpose, we propose a formula with a closed-form solution to estimate a fair, expected, or ex ante value for the Sharpe ratio by framing it in the option pricing model. We find that firm value, growth rate, return volatility, risk-free rate, and the maturity and face value of the debt contract are determinants of the Sharpe ratio. In particular, a firm’s investing and financing policies can affect the firm stock’s Sharpe ratios. Contrary to what might reasonably be expected, our results show that a firm with a higher equity value tends to have a lower Sharpe ratio value. The results show the potential and feasibility of integrating three fields in future research: performance evaluations, option pricing, and corporate finance.