Reading 37: Risk Management －LOS l

The RoMAD (return over maximum drawdown) is the average portfolio return divided by the maximum drawdown. Drawdown refers to the percentage difference between the highest and lowest portfolio values during a period. For example, if the maximum portfolio value during a year was $1000 and the minimum was $900, the drawdown would be 10% [($1000-$900)/$1000]. This measure does not make an assumption of normality in the returns. The standard deviation and Sharpe ratio (which uses the standard deviation in the denominator) both assume a normal distribution of returns. The Sortino ratio examines the downside risk of returns and also assumes a normal distribution of returns.

The Sortino ratio examines the downside risk of returns. It is calculated as the portfolio return minus the minimum acceptable return (MAR) divided by a standard deviation that only uses returns below the MAR. It is similar to the target semivariance. Since Rouses portfolio has had consistently higher returns, she should not be penalized for any variability on the upside. The range (the difference between the highest and lowest values), standard deviation, and Sharpe ratio (which uses the standard deviation in the denominator) examine all returns, whether they correspond to positive or negative alphas. The use of these measures would result in risk measurements that are unfairly high in Rouses case.

The Sortino ratio examines the downside risk of returns. It is calculated as the portfolio return minus the minimum acceptable return (MAR) divided by a standard deviation that only uses returns below the MAR. It is similar to the target semivariance. The other responses refer to other measures of risk-adjusted performance. The Sharpe ratio divides the excess return above the risk-free rate by the standard deviation. An example of a risk-adjusted return on invested capital (RAROC) measure would be to divide the portfolios expected return by the VAR. The RoMAD (return over maximum drawdown) is the average portfolio return divided by the maximum drawdown. Drawdown refers to the percentage difference between the highest and lowest portfolio values during a period.