What is 'Stochastic Modeling'

Stochastic modeling is a form of financial modeling that includes one or more random variables. The purpose of such modeling is to estimate how probable outcomes are within a forecast to predict conditions for different situations. The Monte Carlo simulation is one example of a stochastic model; when used for portfolio evaluation, various simulations of how a portfolio may perform are developed based on probability distributions of individual stock returns.

BREAKING DOWN 'Stochastic Modeling'

Stochastic modeling presents data, or predicts outcomes, all of which account for certain degrees of unpredictability or randomness. Stochastic modeling is used in a variety of industries around the world, many of which are dependent on such models for improving business practices or increasing profitability. For example, the insurance industry relies heavily on stochastic modeling to predict the future of company balance sheets. Other industries and fields of study that depend on stochastic modeling include stock investing, statistics, linguistics, biology, and even quantum physics.

Understanding the Concept of Stochastic Modeling

To understand the sometimes confusing concept of stochastic modeling, it is helpful to compare it to deterministic modeling. While the former produces a variety of answers, estimations or outcomes, deterministic modeling is the opposite. Under deterministic modeling, there is typically only one solution, or answer, to a problem in most elementary mathematics. Deterministic modeling also typically dictates there is only one set of specific values. Alternatively, stochastic modeling can be likened to adding variations to a complex math problem to see its effect on the solution. This process is then repeated in a number of different ways to produce a number of solutions.

Stochastic Modeling in the Investment World

Stochastic investment models attempt to forecast the variations of prices and returns on assets and asset classes, such as bonds and stocks, over time. In the investment world, stochastic models can be classified differently, having different models for single assets and multiple assets. Such modeling is, much of the time, used for financial planning and actuarial work that allows investors and traders to optimize asset allocation as well as asset-liability management.

The significance of stochastic modeling is extensive and far-reaching. The importance of being able to view a variety of outcomes and factor in a variety of variables is unparalleled, and in some industries, it may mean the success or bankruptcy of a company. Because new variables may come into play at any time, and because the number of variables that may have an effect could be high, stochastic models are sometimes run hundreds or even thousands of times, offering potential outcomes for nearly every situation a business, industry, portfolio or agency may face.

RELATED TERMS
  1. Model Risk

    Model risk occurs when a financial model used to measure a firm's ...
  2. Fed Model

    The Fed model is a tool used to determine whether the U.S. stock ...
  3. Predictive Modeling

    Predictive modeling is the process of using known results to ...
  4. Multiple Linear Regression - MLR

    Multiple linear regression (MLR) is a statistical technique that ...
  5. Risk Analysis

    Risk analysis is the process of assessing the likelihood of an ...
  6. Random Variable

    A random variable is a variable whose value is unknown or a function ...
Related Articles
  1. Trading

    Know the Forces at Play Behind the Buy/Sell Cycles

    Weekly stochastics uncover patterns of buying and selling that can be predicted and capitalized on.
  2. Trading

    Best technical indicators to pair with the stochastic oscillator

    Learn how the stochastic oscillator indicator is sensitive to price, and discover technical indicators traders use to complement it such as the RSI and MACD.
  3. Trading

    MACD and Stochastic: A Double-Cross Strategy

    Two indicators are usually better than one. Find out how pairing the stochastic and MACD can enhance your trading, and reveal entry points.
  4. Trading

    4 Double-Cross Buy Signs

    Will the double crossover on MACD and Stochastic indicators trigger a move higher?
  5. Trading

    Build a Profitable Trading Model In 7 Easy Steps

    Trading models can provide a powerful tool for building profit. Traders can use and customize existing trading models or build an original model. This article provides seven steps to building ...
  6. Trading

    MACD And Stochastic: A Double-Cross Strategy

    The stochastic oscillator and the moving average convergence divergence (MACD) are two indicators that work well together.
  7. Trading

    Three Stocks Headed Into Long-term Buy Cycles

    These beaten-down S&P 500 components are finishing up long-term sell cycles that should yield strong multi-month bounces.
  8. Investing

    Financial Models You Can Create With Excel

    The relatively modest amount of time it takes to build these models can pay for itself by leading you to better investment decisions.
  9. Financial Advisor

    Advisor Fees: A Look At the Retainer Model

    Financial advisors may want to become familiar with new payment models sooner rather than later in order to proactively meet market demands.
  10. Trading

    3 Nasdaq-100 Stocks at or Near Monthly Buy Signals

    Monthly Stochastics crossovers identify significant turning points where shareholder supply and demand can shift forcefully.
RELATED FAQS
  1. Is a Slow Stochastic Effective in Day Trading?

    The good news is that most technical indicators can be adjusted to be of value to a day trader. Read Answer >>
  2. How do I read and interpret an Stochastic Oscillator?

    Understand the basics of the stochastic oscillator and how analysts and traders use this measure of trend momentum to predicts ... Read Answer >>
  3. What is the difference between financial forecasting and financial modeling?

    Understand the difference between financial forecasting and financial modeling, and learn why a company should conduct both ... Read Answer >>
  4. What are some examples of ways that sensitivity analysis can be used?

    Understand the concept of sensitivity analysis and learn about the wide variety of disciplines to which it can be applied. Read Answer >>
  5. What are some examples of different corporate governance systems across the world?

    Read about the three major types of corporate governance systems: the Japanese model, the Anglo-Saxon model and the continental ... Read Answer >>
  6. What are the most common momentum oscillators used in day trading?

    Take a look at some commonly used momentum oscillators that can also be used for intraday trading, such as stochastic oscillators ... Read Answer >>
Trading Center