medium · FRM Part 2 Risk & Investment Management
According to the 'Peso Problem' in performance measurement, why might a high Sharpe ratio be misleading for a strategy like merger arbitrage or carry trades?
- The calculation simply relies on an inappropriate risk-free rate benchmark, which distorts the excess return in the numerator of the ratio.
- The strategy is market-neutral by construction, so it should theoretically produce a Sharpe ratio of exactly zero over any measurement period.
- The strategy harvests small steady gains but carries rare, catastrophic tail risk that may not appear in the historical sample.
- High portfolio turnover generates transaction costs that the Sharpe ratio calculation systematically fails to deduct from returns.
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