Suppose that the market portfolio is composed of two stocks, which we call Stock A and Stock B. Stock A has a market capitalization of $600 million, an expected return of 15% (EAR), and a volatility of 40%. Stock B has a market capitalization of $400 million, an expected return of 10% (EAR), and a volatility of 25%. The correlation between Stock A and Stock B is zero. The return on Treasury bills is 5% (EAR).

Part A: Alice intends to invest in the market portfolio and Treasury Bills. She desires an expected return of 20%. What fractions of her wealth should she invest in the market portfolio and Treasury Bills to achieve this expected return?

Part B: What is the volatility of Alices portfolio?

Part C: Does the CAPM hold in this setting?

Part D: Suppose now that Stock A and Stock B have the same market capitalizations and volatilities as in Part A. Stock A and Stock B are still uncorrelated. However, the expected return on Stock A is now 12%. Supposing that the CAPM holds, what must be the expected return on Stock B?

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