Question

Explain the Two-Factor model by Merton.

Compare the APT with the CAPM

Answer 1

1. Two factor model by Morten is a model which is used to access the credit risk of debt payable of a company and it is used to to get an understanding of capability of company in order to meet with the financial obligation and debt servicing.

The two factor model is based upon analysis of credit risk of a company and it is used to tell about the risk of a corporation credit default and it is used for easy evaluation of company and it will also help to analyse, if company is able to retain solvency by analysing maturity dates and debt total.

This model is based upon various assumptions like no dividend are paid and all the options are European options and the market movements are unpredictable.

2. There is a difference between Capital Asset pricing model and Arbitrage pricing theory model.

Capital Asset pricing model will only be looking at the sensitivity of the Asset where as arbitrage pricing theory looks at various different factors that can be divided into microeconomic factors or and unsystematic factors.

Arbitrage pricing theory is believed to be more accurate than Capital Asset pricing model whereas Capital Asset pricing model is not that efficient as arbitrage pricing model.

Arbitrage pricing model is requiring additional effort and time not only to calculate but also to determine what factors to use and gather relevant data to find the beta in relation to its factor whereas Capital Asset pricing model will be looking at volatility and systematic risk in order to find out the beta.