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).

Choice A is incorrect. The sensitivity of an asset to inflation is measured by its beta coefficient with respect to inflation. Given that both Asset X and Asset Y have the same beta coefficient for inflation ($\beta_{X,IF} = \beta_{Y,IF} = 2$), it implies that they are equally sensitive to unexpected changes in inflation. Therefore, it is not correct to say that Asset Y is more sensitive to inflation than Asset X.

Choice B is incorrect. The effect of a factor on the returns of an asset is determined by its beta coefficient with respect to that factor. Since both assets have the same beta coefficients for both factors ($\beta_{X,IF} = \beta_{Y,IF} = 2$ and $\beta_{X,CS} = \beta_{Y,CS} = 2$), it means that unexpected changes in either inflation or consumer sentiment will have the same effect on the returns of Assets X and Y. Thus, this statement is false.

Choice D is incorrect. Both assets have the same beta values for both factors. Moreover, the expected returns provided show that $E(R_Y) = 12\%$ and $E(R_X) = 10\%$, indicating that asset Y has higher expected returns, not asset X.

Things to Remember

• Arbitrage is a key concept in finance that involves exploiting price differences in different markets to make risk-free profits.
• Beta coefficients measure the sensitivity of an asset's returns to changes in a particular factor, such as inflation or consumer sentiment.
• Expected returns are a key component in asset pricing models and help investors