Given the following probability distributions for Stocks A and B, and the market portfolio, M:

StateProbabilityReturn on AReturn on BReturn on M

Bust0.15-0.10-0.18 -0.15

Normal 0.600.090.120.12

Boom0.250.320.260.25

You construct a 2-stock portfolio by investing $28,000 in Stock A and $12,000 in Stock B.

(a)Compute the expected rate of return and variance of the 2-stock portfolio that is composed of Stocks A and B.

(b)Given that the beta for stock A is 1.0197, compute the required (CAPM) rate of return on the 2-stock portfolio, given that the risk-free rate and the inflation rate are, respectively, 0.025 and 0.020.Explain your investment recommendation on the 2-stock portfolio according to the CAPM analysis.

(Hint:You need to compute the beta for Stock B, given that expected return and standard deviation for the market portfolio are, respectively, 0.1120 and 0.1229!)