Question

1.Explain the Two-Factor model by Merton.

2.Explain the Fama-French Three-Factor Model.

Answer 1

1. Two factor model by merton is a model which is used to access the credit risk of debt of the company.

It is used to understand how capable a company is in order to meet financial obligation and service debt.

This model is based upon various kinds of assumption which will include that dividend are never paid out and all the options are European options and they are exercised at the time of the expiration in the market movements and unpredictable and no commissions are included so this model is used to to provide a structural relationship between default risk and the Asset of the company.

2. Fama and French three factor model is a asset pricing model which will be adding risk size and value factor to the the market risk factor of Capital Asset pricing model and it will be considering the fact that small caps and value stocks are all outperforming on a regular basis so this model will be expanding the Capital Asset pricing model by adding size risk and value factor to the market risk factors and this model is essentially the result of an econometric regression of historical stock prices.