How is the Sharpe Ratio calculated?

The Sharpe Ratio is a measure used to evaluate the risk-adjusted return of an investment or portfolio. The correct calculation involves taking the difference between the portfolio's return and the risk-free rate, which reflects the excess return that investors earn for taking on additional risk. This excess return is then divided by the standard deviation of the portfolio’s returns, which measures the volatility or risk associated with those returns.

In essence, the Sharpe Ratio provides a way to understand how much excess return an investor is receiving for the extra volatility they endure relative to a risk-free investment. By incorporating both the excess return and the standard deviation, the Sharpe Ratio allows investors to compare the risks associated with various investment strategies or portfolios on a standardized basis. This makes it a valuable tool for making informed investment decisions.

The other options either convey incomplete or incorrect elements of the Sharpe Ratio calculation, such as suggesting just the excess return or performance against a benchmark without adequately addressing the role of risk and standard deviation in the calculation process.