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Introduction to Stochastic Processes 30July2011

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# Introduction to Stochastic Processes

U Dinesh Kumar

Characteristics of SP. Types of SP. .    Strength and Weakness of SP models.Lecture Outline  Introduction and definition of SP.

In mathematics. You just get used to them . you don't understand things.J von Neumann .

  .Stochastic Processes . If the index set T is countable set. then the process X(t) is a discrete-time stochastic process. t T} is a collection of random variables indexed by t. The index t is usually assumed to be time and the random variable X(t) is the state of system at time t. then X(t) is called continuous time process.Definition  A stochastic process is a model that evolves in time or space subject to probabilistic laws. If T is continuous. A stochastic process {X(t).

It is all most impossible to find a problem in business which does not change with time and has no uncertainty. Often. SP is the only tool which can model realistic problems in business and management.Importance of Stochastic Process  Theory of stochastic processes aims to model the interaction of “chance” and “time”.  .

Path of SP X(t)  The values taken by SP X(t) for various values of t is called the path of the SP X(t) a random variable for each fixed t X(t) a sample path t time .

State Space  The range of possible values of SP. X{t}. is called the state space. Discrete State Space  Number of customers  Credit Rating Continuous State Space  Market Share  Stock Price    . The state space can be either discrete or continuous.

Examples of SP          Cash flow Market Share Stock Price Customer Retention Customer Satisfaction Inventory Level Commodity Price Product and service demand Availability of engineering systems .

…. X(t3) – X(t2).  . X(t2) – X(t1). X(tn) – X(tn1) are independent. In an independent increment process.Stochastic Processes: Independent Increment  A continuous time SP {X(t)} is said to have independent increments if for all t0 < t1 < t2 < …< tn: the random variables:  X(t1) – X(t0). the change in the non-overlapping time intervals are independent.

the distribution of change between two points depends only on the distance between the two points.Stationary Processes  A SP is said to have stationary increments if X(t+s) – X(t) has same distributions for all t.  . In a stationary process.

Types of Stochastic Processes       Poisson Process Renewal Process Markov Process Martingales Random Walks Brownian Motion Process .

 All most all problems in finance. marketing and operations have random element and the distribution of randomness changes over a period of time. .Strength of SP  The element of randomness exists in any process and thus you need a tool that can model changing phenomena.

Weakness of SP  The SP models in many cases can be intractable.  . Many SP models are still unsolved.

1975    H C Tijms. “Introduction to Stochastic Processes”. Prentice Hall. 2006. “Introduction to Probability Models”.Recommended Readings Ross. Academic Press. “Stochastic Models – An Algorithmic Approach”. . S M. John Wiley. E Cinlar. 1994.

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