## Omega Ratio Definition

The omega ratio is a weighted risk-return ratio for a given level of expected return that helps us to identify the chances of winning in comparison to loosing (higher the better). It also considers the third and fourth momentum effect i.e., skewness & Kurtosis, which gives this an immense usefulness in comparison to others.

For calculating the omega ratio, we require the cumulative excess return of the Asset. Basically, we need to calculate all the high and low in a cumulative manner.

### The formula of Omega Ratio

In simple form, the omega ratio formula can be understood as follows

**Omega Ratio = ΣWinning – Benchmarking / ΣBenchmarking – Loosing**

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For eg:

Source: Omega Ratio (wallstreetmojo.com)

### Example of Omega Ratio

Standard DeviationStandard DeviationStandard deviation (SD) is a popular statistical tool represented by the Greek letter 'σ' to measure the variation or dispersion of a set of data values relative to its mean (average), thus interpreting the data's reliability.read more = 4%, Mean Return = 6%

**Return Earned in Past**

Period | Return (X) | Excess Return (X- x̄) |
---|---|---|

1 | 8% | 2% |

2 | 9% | 3% |

3 | 7% | 1% |

4 | 15% | 9% |

5 | 2% | -4% |

6 | 3% | -3% |

7 | 4% | -2% |

8 | 5% | -1% |

9 | 6% | 0% |

10 | 1% | -5% |

Omega Ratio formula = ∑ Winning – Benchmarking / ∑ Benchmarking – Losing

= ∑ 15/ ∑ 15

**Omega Ratio =1 **

### Types of Omega Ratio

There are various measures that are used by the organization to check their risk in comparison to risk undertaken. As per the term structure theory of Fixed incomeFixed IncomeFixed Income refers to those investments that pay fixed interests and dividends to the investors until maturity. Government and corporate bonds are examples of fixed income investments.read more, people are willing to take the risk if they are compensated in the form of higher returns. The higher return should be support by the higher risk, but there should be a trade-off so that higher returns can actually be seen after adjusting on a risk-adjusted basis.

Any ratio used to check the performance should be used in conjunction with another ratio, not in isolation.

The following are different measures of the omega ratio.

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- Treynor RatioTreynor RatioThe Treynor ratio is similar to the Sharpe ratio and it calculates excess return over risk-free return per unit of portfolio volatility using beta rather than standard deviation as a risk measure. As a result, it gives the excess return over the risk-free rate of return per unit of the beta of the investor's overall portfolio.read more – Excess return earned/ Beta
- Sharpe RatioSharpe RatioSharpe Ratio, also known as Sharpe Measure, is a financial metric used to describe the investors’ excess return for the additional volatility experienced to hold a risky asset. You can calculate it by, Sharpe Ratio = {(Average Investment Rate of Return – Risk-Free Rate)/Standard Deviation of Investment Return} read more – Excess return earned/ Standard Deviation
- Sortino RatioSortino RatioThe Sortino ratio is a statistical tool used to evaluate the return on investment for a given level of bad risk. It is calculated by subtracting the risk-free rate of return from the expected return and dividing the result by the negative portfolio's standard deviation (downside deviation).read more – Excess return/ Downward Standard deviation
- Jensen Alpha – Return on a portfolio – Return as per Capital asset pricing model (CAPM)Capital Asset Pricing Model (CAPM)The Capital Asset Pricing Model (CAPM) defines the expected return from a portfolio of various securities with varying degrees of risk. It also considers the volatility of a particular security in relation to the market.read more i.e., Excess Return in percentage.

### Benefits

- It covers all the distribution, whether normal or left or right-skewed.
- It covers all the risk-return attributes. Mean, Standard deviation, Kurtosis, skewness. This is the main advantage of using this ratio, which is not tackled by any other similar ratio that makes it superior over others.
- Omega ratio is useful in the case of a hedge fund where they invest in some exotic financial products where the Asset does not have a distribution, which is normal.
- They are mostly used by a hedge fundHedge FundA hedge fund is an aggressively invested portfolio made through pooling of various investors and institutional investor’s fund. It supports various assets providing high returns in exchange for higher risk through multiple risk management and hedging techniques.read more that uses long/short strategies to earn an arbitrage.
- In real life, no asset class can fit into the normal distribution; it provides a better result in this picture.
- The omega calculation usefulness can be seen as it uses kithe actual return distribution instead of normal distribution. So the omega ratio responds accurately to the past analysis of the risk-return distribution of the investment being considered.
- The mutual fundMutual FundA mutual fund is an investment fund that investors professionally manage by pooling money from multiple investors to initiate investment in securities individually held to provide greater diversification, long term gains and lower level of risks.read more invests in a diversified portfolio. It’s commonly used over here to check the performance and indicator of the likelihood of estimates.
- It rewards those portfolios which provide an excess return in comparison to losses.
- Easy to provide ranking to portfolio or asset class through omega ratio

### Limitations

- Heavy reliance on ratio can be a blunder because of using past data and nonstationarity in using the lookback data.
- It makes the resulting complex for a small investor, only useful for sophisticated investors.
- Dependency on another ratio. It cannot independently rely only on itself.
- It is heavily affected by the outliers that make the result affected heavily.
- Value at Risk (VAR), Scenario Analysis, stress-based testing is also needed if the Asset under management(AUM) is high.
- Hedge funds charge fees in the form of carried interest and management fees for managing the fund. Omega helps to find out the ranking considering the effect of risk with return component, but after considering the high fees of the fund, the result can show a slightly different picture than before considers the effect of that component.

### Conclusion

The omega ratio is useful in choosing the portfolio as per the desired profile of the investor. Some investors (Risk-averse people) want that they should at least earn the minimum rate of return that is saving rate provided by the bank, or even more risk-averse people want that at least their capital should not be at risk. One can check their risk toleranceRisk ToleranceRisk tolerance is the investors' potential and willingness to bear the uncertainties associated with their investment portfolios. It is influenced by multiple individual constraints like the investor's age, income, investment objective, responsibilities and financial condition.read more level and risk appetite ability to choose low or high omega ratio to align; they require a risk-return profile with the particular class.

### Recommended Articles

This has been a guide to what is Omega Ratio and its definition. Here we discuss formula to calculate the omega ratio along with its example, benefits, and limitations. You can learn more about budgeting from the following articles –

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