Suppose you group all the stocks in the world into two mutually exclusive portfolios (each stock is in only one portfolio): growth stocks and value stocks. Suppose the two portfolios have equal size (in terms of total value), a correlation of 0.5, and the following characteristics:

Expected Return Volatility Value Stocks 15% 14%

Growth Stocks 19% 29%

The risk-free rate is 3%.

a. What is the expected return and volatility of the market portfolio (which is a 50–50 combination of the two portfolios)?

b. Does the CAPM hold in this economy? (Hint : Is the market portfolio efficient?)

Determining the Risk Premium AppendixLO1