Definition: Stochastic is the random occurrence of a given event. It is a statistical term that refers to situations that can’t be expected or predicted.
What Does Stochastic Mean in Business?
The word stochastic originates from the Greek stochastikos, which means, “able to guess”. It is often employed to describe different scenarios where concise results can’t be obtained since there is a random variable that will cause the outcome to vary each time the phenomenon is observed. In the field of statistics, a stochastic approach means to input different values to a given random variable in order to develop a probabilistic distribution where patterns can be identified.
Nevertheless, since the term refers to scenarios with unexpected results these probabilistic approaches have limited applicability. On the other hand, stochastic predictions can also be derived from previous observation of the situation. A company that already has many years selling its products on a stable market can create a reliable forecast of its sales, even if the event of buying a product itself is somehow random. Companies can predict district, city, state, region and national sales figures, by using forecasting models based on past data. A stochastic variable can, nevertheless, be incorporated in these models, to evaluate different possible scenarios.
Example
Liu & Co. is a financial services firm that conducts day trading operations for complex financial instruments in many financial markets around the world. The company is currently developing a forecasting model for a given category of securities to predict its prices. Since the financial market is in itself a stochastic environment, the founder of the company Mr. Liu, has identified several variables that have a fairly considerable influence in the price of securities.
He designed a model where 10 variables are evaluated to derive a price for the security. Some of these variables have steady values that have a predictable conduct but the other three are considered random. In order to calculate a range of possible prices, Mr. Liu inputs different random values to each, through a stochastic model, to achieve a probability distribution where the trader can identify the most probable price for the asset. This system have proven very profitable in the past and it is already being used by various other financial firms.
