Omega Ratio

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

Formula1

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

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

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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

PeriodReturn (X)Excess Return (X- x̄)
18%2%
29%3%
37%1%
415%9%
52%-4%
63%-3%
74%-2%
85%-1%
96%0%
101%-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.

Types of Omega Ratio

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Benefits

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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