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A methodology for computing and comparing implied equity and corporate-debt Sharpe Ratios

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Abstract

This paper presents a macro-economic methodology for evaluating the forward-looking Sharpe Ratios of the equity and debt components of the United States public company capital structure. Using this framework, it is shown that the equity and debt Sharpe Ratios are both time variant and disparate. The methodology is used to review the risk aversion behavior of equity and debt market participants surrounding the past three major market events, the 1987 crash, the 2000–2001 Internet bubble and the 2008–2009 credit crisis. The forward-looking Sharpe Ratios are used to construct a dynamic portfolio of stocks and corporate bonds that outperforms a static portfolio on a risk-adjusted basis. This paper then offers market segmentation and the differing behavior of equity and corporate bond investors as an explanation for the observed Sharpe Ratios.

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Notes

  1. The Markowitz two asset optimization with a zero correlation results in an equity weight = λ et /[λ et  + λ dt  * (σ et /σ dt )].

  2. The Markowitz two asset optimization with a negative one correlation results in an equity weight = 1/[1 + * (σ et/σ dt )]. Equation (11) can be rewritten as W et  = 1/[1 + (σ et /σ dt ) * (K Et − r et )/(K dt − r dt )].

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Acknowledgments

The author acknowledges with thanks the comments and feedback of Ehud Ronn, Michael Evelyn, Jayen Patel and the anonymous referees. The author remains solely responsible for any errors in the paper.

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  1. Robert B. Willumstad School of Business, Adelphi University, 1 South Ave, Garden City, NY, 11530, USA

    Robert S. Goldberg

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  1. Robert S. Goldberg
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Correspondence to Robert S. Goldberg.

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Goldberg, R.S. A methodology for computing and comparing implied equity and corporate-debt Sharpe Ratios. Rev Quant Finan Acc 44, 733–754 (2015). https://doi.org/10.1007/s11156-013-0424-2

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