Financial Risk Manager Part 1
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An arbitrage opportunity exists. Arbitrage is the practice of taking advantage of a price difference between two or more markets, striking a combination of matching deals that capitalize upon the imbalance, the profit being the difference between the market prices. In this case, the two assets, X and Y, have identical systematic risks as indicated by their beta coefficients. However, they have different expected returns, with asset Y having a higher expected return than asset X. This discrepancy creates an arbitrage opportunity. An investor can exploit this by shorting asset X (i.e., selling asset X now with the intention of buying it back later at a lower price) and using the proceeds to take a long position in asset Y (i.e., buying asset Y now with the expectation that its price will increase in the future). This strategy allows the investor to make a risk-free profit, as they are essentially borrowing at a lower rate (the expected return of asset X) and investing at a higher rate (the expected return of asset Y).
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Explanation:
Explanation
Correct Answer: C
An arbitrage opportunity exists because:
- Both assets X and Y have identical systematic risk (same beta coefficients: βX,IF = βY,IF = 2 and βX,CS = βY,CS = 2)
- However, they have different expected returns (E(RY) = 12% vs E(RX) = 10%)
- This creates a pricing inconsistency that can be exploited for risk-free profit
Arbitrage Strategy:
- Short asset X (borrow and sell)
- Use proceeds to buy asset Y
- Since both assets have identical risk profiles but different returns, this creates a risk-free profit opportunity
Why other options are incorrect:
- A: Both assets have the same inflation beta (βX,IF = βY,IF = 2), so they are equally sensitive to inflation
- B: Both assets have identical beta coefficients for both factors, so unexpected changes affect them equally
- D: Asset Y actually has higher expected returns (12% vs 10%), not asset X
This scenario represents a classic arbitrage opportunity where assets with identical risk characteristics should have identical expected returns according to arbitrage pricing theory.
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