Market Risk Premium

A fund's beta tells you how sensitive it is to the market. Market Risk Premium tells you how much the market itself is paying investors for taking that risk in the first place — the extra return a benchmark index earns above a risk-free security like a T-bill.

Multiply beta by the market risk premium and add the risk-free rate, and you get the return a fund was entitled to given the risk it took — the "expected return" that alpha is then measured against.

Under the Capital Asset Pricing Model used throughout the workbook's alpha discussion, expected return is:

E(R) = Rf + β × (Rm − Rf)

where Rm − Rf is the Market Risk Premium: the excess return generated by the benchmark or selected broad-based index over the risk-free rate. Rm is specifically the benchmark's own return, not an abstract market-wide figure — which is why the choice of benchmark, through the Benchmarking Agency framework, feeds directly into this number.

The workbook's own reasoning: if the premium is high, it is beneficial for the investor to invest in that category of investments, funds or broad-based indices — a high market risk premium is the market rewarding risk generously; a low one means the market is offering little extra compensation for taking it on.

Using the workbook's own Fund XYZ scenario: the 364-day T-bill rate (Rf) is 5.60%, and the 1-year CRISIL AIF Index – Category III (Rm) returns 9.25% over the same period.

Market Risk Premium = Rm − Rf = 9.25% − 5.60% = 3.65%

For a fund with a portfolio beta of 1.30, the risk-adjusted expected return becomes 5.60% + 1.30 × 3.65% = 10.35% — meaning the market risk premium alone contributed 4.745 percentage points of that expected return, before the risk-free rate is even added back in.

If the benchmark had instead returned only 7.00% for the same period (a lower Rm), the market risk premium would fall to 7.00% − 5.60% = 1.40%, and the same fund at beta 1.30 would only be expected to earn 5.60% + 1.30 × 1.40% = 7.42% — a materially lower bar to clear before any alpha is generated at all.

Chapter 6 (Fees Structure, Fund Performance and Benchmarking), in the alpha and CAPM discussion, names each of the three CAPM inputs individually — risk-free rate, beta and market risk premium — before combining them into the expected return formula used in the Fund XYZ worked example. Expect Market Risk Premium tested as one line of a multi-step alpha calculation, where a candidate must first compute Rm − Rf before multiplying by beta.

• Market risk premium is Rm − Rf, computed first, then multiplied by beta. A common error is multiplying beta by Rm alone and forgetting to net off Rf first.
• Rm is the benchmark's return, not the fund's own return. Using the fund's actual return in this formula instead of the benchmark's produces a meaningless number.
• A higher market risk premium raises the bar a fund must clear to show positive alpha, holding beta constant — it does not, by itself, tell you anything about whether the fund actually generated alpha.
• Market risk premium changes whenever the benchmark or the risk-free rate changes — it is not a fixed constant across different periods or different Category III AIF valuations.