Sharpe's ratio for pairs trading

Hi,

I'm trying to calculate the sharpe ratio for pair trading with different parameters that trigger when to enter and exit a position.

http://en.wikipedia.org/wiki/Sharpe_ratio introduces a "risk-free rate of return" factor whih I really don't understand.

If anyone has done this, please tell me what you used for the variable Rf


Regards
Adam

Risk free rate is usually the base interest rate for your accounting currency.

E.g. for USD based accounts it would be interest rate on money market or short term treasury bills. At present it is virtually zero.

The idea is that Sharpe above zero has to mean that you earned more than a supposedly riskless money market/bank account.

Risk free rate of return is the money you can make without risk of default.

E.g. US treasury bonds will never default, therefore, the risk free rate of return is the interest rate on those treasury bonds.

Companies traded on the stock market can default, and thus, the risk free rate of return is 0.

With regard to forex, the risk free rate of return would probably be based off of the particular currencies' central bank interest rates. This will always apply to the G-8, assuming you don't think those countries will go bankrupt. However, there are some instances where a currency pair has risk. Iceland went bankrupt I believe.

Well I'm looking at trading futures contracts. Forgive my ignorance as I'm a programmer with little knowledge of financial terms.

Would I assume the risk free rate of return is zero since commodities are on an international market. Is that a suitable assunption?

On the wikipedia page again I assume "R" is a vector of the return from individual trades, with commission and charges subtracted from those returns.

Thanks for the help

No, it's not a suitable assumption. If you invest in commodities, then the risk is huge.
The risk free rate of return is located in fixed income financial instruments (bonds). But not all bonds are risk free. For e.g. the bonds which are rated as "junk bonds" have the biggest risk.
Dig on the internet the difference between bonds market and commodities.
happy new year.

Risk free rate of return basically means the return rate that you would get for your money on the same period without risk.

As there actually are no such investments, some very low risk government bonds (three month treasury for USD for example) where rate is known is quite a good number that you could use (for the same currency because otherwise you are discounting the currency risk). Most of the commodity futures are usually USD based so if you are trading them, use US treasury bonds.

Note that risk-free return is not market dependant factor so you can use the same number for all markets (as long as it's the same currency)

One question you might want to ask yourself is is sharpe really what you want to use or would sortino, profit factor or mar be better.

Risk free return: Bank interest. Here in the US, it's a dazzling 1.5% for me