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The Omega ratio is a way of measuring the performance of financial assets based on the level of returns they offer in return for the risk of investing in them. It is a ratio of weighted gains to weighted losses — a ratio that includes information about the probability of each level of returns. In contrast to its predecessors, the Omega ratio differs according to the shape of the distribution of an asset’s returns. This allows investors to distinguish between assets with different risk profiles.
Investors generally demand compensation for taking risks in the form of higher returns. Economic analysts have devised ways of evaluating assets in these terms to give investors information about which assets provide the best returns for the level of risk that they present. One of the most often used reporting measures is the Sharpe ratio, which is the ratio of the mean return of the asset minus the riskless return, which is usually the return on Treasury bonds, to a measure of the asset’s volatility, which is found using the variance of the returns.
Although the Sharpe ratio is commonly used to evaluate the performance of an asset, it has significant shortcomings. The measurement is based on the mean and variance of the asset’s returns, which tells an investor little about the asset’s actual performance. Many distributions of returns can have the same mean and variance but completely different shapes, which means they have different probabilities for any given return. The actual shape of the distribution is important to the investor because it tells him the probability of different levels of return, giving him a better idea of the risk to which he is exposed.
The Omega ratio is an alternative measure of asset performance that gives the investor the information the Sharpe ratio discards. It incorporates the entire distribution of returns without burdening the analyst with difficult calculations. Con Keating, a fund manager with experience as a financial analyst, and William F. Shadwick, a mathematician, proposed the measurement in 2002. Their paper, “A Universal Performance Measure,” described the measurement and how to calculate it, and it provided an analysis of the benefits of using a ratio which avoided oversimplifying the returns data of assets.
To calculate the Omega ratio, an analyst must know the distribution function of an asset’s returns. The analyst chooses a loss threshold at which to evaluate the asset. He calculates the area between a horizontal line at one and the distribution function, or the area above the curve, for returns above the threshold. Then, he calculates the area under the curve and above zero for returns below the threshold. The Omega ratio is the first number divided by the second.