Answer: Asset X is undervalued relative to Asset Y

## Explanation In a two-factor model, the expected return of an asset is given by: $$E(R_i) = R_f + \beta_{i,IF} \times \lambda_{IF} + \beta_{i,CS} \times \lambda_{CS}$$ Where: - $R_f$ is the risk-free rate - $\lambda_{IF}$ is the risk premium for inflation factor - $\lambda_{CS}$ is the risk premium for consumer sentiment factor Given that both assets have identical factor exposures: - $\beta_{X,IF} = \beta_{Y,IF} = 2$ - $\beta_{X,CS} = \beta_{Y,CS} = 2$ This means both assets should have the same expected return if they are fairly priced. However, we observe: - $E(R_X) = 10\%$ - $E(R_Y) = 12\%$ Since both assets have identical factor sensitivities, they should command the same risk premium. Therefore, the asset with the lower expected return (Asset X) is **undervalued** relative to the asset with the higher expected return (Asset Y). **Key Insight**: When two assets have identical factor exposures, they should have identical expected returns. Any difference in expected returns indicates mispricing, with the lower-return asset being undervalued relative to the higher-return asset.

Author: Tanishq Prabhu