The table provides factor risk loadings and factor risk premia for a two-factor model for a particular portfolio where factor portfolio 1 tracks Inflation and factor portfolio 2, IR, tracks unexpected changes in interest rates. The risk-free rate is 3%. If a trader estimates the expected / average return of the Portfolio XYZ to be 3.5% and believes that he is correct, what is the arbitrage strategy?

Portfolio XYZ Factor Loading Risk Premium Inflation 0.5 8% IR -1.5 2%

1. Long XYZ, Short Inflation, Long IR, Buy Risk-Free 2. Short XYZ, Long Inflation, Long IR, Buy Risk-Free 3. Short XYZ, Short Inflation, Short I, Buy Risk-Free 4. Short XYZ, Long Inflation, Short IR, Buy Risk-Free 5. Short XYZ. Long Inflation. Short IR. Borrow Risk-Free