STOCHASTIC AND DETERMINISTIC MODELS

A model is an imitation of the real world situation or system.Models are generally developed for activities like,economy of a country,share prices of a company,future interest rates in the market etc. Models are prepared to reduce the risk arising due to the uncertain nature of the environment.A model helps to take advantage of future opportunities as well as save us from adverse situations of the future time.The main advantage of modelling is that systems with long time frames can be studied in compressed time frames.

STOCHASTIC MODELS

A stochastic model is the one that recognizes the random nature of the variables.The output is only an estimate of the nature of the model with given set of inputs.Software is run several times to give a distribution of results of the model.

DETERMINISTIC MODEL

A model that doesn’t contain any random variable is a deterministic model.A deterministic model is a special kind of stochastic model with zero randomness.In a deterministic model a single output is obtained with a fixed series of inputs.

EXAMPLE SHOWING DIFFERENCE BETWEEN THEM

An investor bought some shares worth $5000 with an expected growth of 7%.

Under deterministic model value of shares after one year would be 5000*1.07=$5350

Under stochastic model growth will be random and can take any value,for eg, growth rate is 20% with probability of  10% or 0% growth with probability 205%, but the average growth rate should be 7%. In this way we will get a distribution of results as value of share can be $5000,$5500,$4000 etc.

The followings points highlight the main difference between the two;

• Stochastic model recognizes the random nature of variables, whereas, deterministic models does not include random variables.
• Stochastic models uses random numbers to do calculations and output determined is also random in nature,whereas,in deterministic model once the inputs are fixed output values can be determined which are also fixed in nature.
• Stochastic model gives distribution of possible results ,whereas,single set of output is determined in deterministic model.
• More complicated methods like monte carlo simulation, are used for calculations in stochastic models as compared to the direct methods of calculation used in deterministic models.

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