When to Use Stochastic Model more Appropriate
Hi,
When I am looking at the battle quiz on when a stochastic model is more appropriate.
It says when the risk distribution are easily inferred (e.g. CAT). May I know what does this mean, like more volatile?
It then also says that capital market risks is also reason, not quite sure what this mean as well.
Thanks and Cheers,
Wilson
Comments
Hi Wilson,
A stochastic model means that predictions of losses are made using a probability distribution. A deterministic model means you just average the losses for the last 10 years (or something similar). A stochastic model is generally considered better because it describes the underlying process mathematically, but it's harder to apply because it requires that you have the corresponding probability distribution.
The example of stochastic models for catastrophes is mentioned because we have lots of historical data related to catastrophes so we have a pretty good idea of what the loss distribution of catastrophe events looks like.
Regarding capital market risks, this is the risk associated with investing. The FCT source text doesn't go into any detail but this type of risk has been studied extensively by financial analysts and there are mathematical models that describe these risks quite well. That's why it's listed as an example of where stochastic models are appropriate.
I see. Thanks Graham. I just searched up, Statistical inference is the process of drawing conclusions about an underlying population based on a sample or subset of the data. So if there is not much statistical inference meaning we cannot really draw up meaningful conclusion from the distribution itself, then Deterministic would be a better way. I think now I understand.
Yup, that's it!