An equity mutual fund scheme achieves an annualized return of 14.0% with an annualized standard deviation of 4.0%. If the risk-free rate of return in the economy is 6.0%, what is the Sharpe Ratio of the scheme?

[ A ]3.50

[ B ]2.00[ CORRECT ]

[ C ]0.50

[ D ]1.25

Takeaway

Option B is correct: 2.00

Derivation

The Sharpe Ratio measures the excess return (risk premium) generated per unit of total risk (standard deviation). Formula: Sharpe Ratio = (Scheme Return (Rs) - Risk-Free Rate (Rf)) / Standard Deviation (Sigma). Substituting the values: Sharpe Ratio = (14.0% - 6.0%) / 4.0% = 8.0% / 4.0% = 2.00. A higher Sharpe Ratio indicates that the fund manager generated higher excess returns relative to the total portfolio volatility assumed. This question tests the mathematical computation and interpretation of Sharpe Ratio. The primary pitfall is dividing total return (14.0 / 4.0 = 3.50) without subtracting the risk-free rate.

Why the others fail

A — 3.50

3.50 results from dividing total scheme return (14%) by standard deviation (4%) without deducting the risk-free rate (6%).

C — 0.50

0.50 is the mathematical inverse resulting from dividing standard deviation by risk premium (4.0 / 8.0).

D — 1.25

1.25 results from incorrectly subtracting standard deviation from risk-free rate and dividing by total return.