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Overview Of Stochastic Process

Farhad Malik Follow
Oct 25, 2018 · 4 min read

This article provides an overview of stochastic process and fundamental

mathematical concepts that are important to understand.

Stochastic variable is a variable that moves in random order. Exchange

rates, interest rates or stock prices are stochastic in nature. Stochastic
variables can follow wiener or Itos process. I will start by explaining what
stochastic process is.

These concept are crucial to understand in machine

learning, :nance and risk management.

What Is A Stochastic Process?

Think of a stochastic process as how smoke particles collide with each other.
Their unpredictable movements and collisions are random and are referred
to as Brownian Motion.

Interest rate is a variable that changes its value over time. It is not
straightforward to forecast its movements.

There are two ways to classify a stochastic process:

1. Discrete: When changes in value of a variable are at Dxed points in time.

Only certain values can be chosen for a discrete variable.

2. Continuous: When changes in value of a variable are continuous. Value

of a continuous variable can take any value within a certain range.

Stochastic process can also be Markov.

Markov Stochastic Process

For time series data, past of the variable can help predict its present and
future values. On the other hand, markov process is one where the past is
irrelevant.

Key Note: Markov process is where value of a

variable does not depend on its historic values.

Only the current value of the variable can be taken into account to predict
the future values. As a result, future predictions are expressed in probability
distributions. As an instance, a variable might follow normal or log normal
probability distribution.

It is important to understand that each probability distribution has a mean

and variance where the mean is the average value and variance is the
dispersion of values from its mean.

Mean is also known as return and variance is known as risk as it adds

uncertainty in your variable’s values.

Key Note: Stochastic evolution process is about

using probability distribution of a variable to evolve
it over time.

Wiener Process
Markov stochastic process can also have a normal distribution with a mean
change of 0 and variance rate of 1. This is known as Wiener process. It is a
specialised form of Markov Stochastic Process.

Therefore Wiener process is where a normally

distributed variable is evolved.

Variable changes across two diLerent time steps are not dependent on each
other. A variable follows Wiener process if following two conditions are
met:

Variable Change = Normal Distribution Number(mean=0, variance=1) *

Sqrt(Change In Time)

Drift and Variance Rate

Drift rate is the change in mean per unit of time whereas variance rate is the
change in variance per unit of time.

Key Note: In a Wiener process, expected drift and

variance rate is constant.

Ito’s Process
Ito’s process is a stochastic process. Drift and variance rates are functions on
current value and time. As a result, drift and variance rates change over
time. It implies that the values of a variable depend on the past values of the
variable.

Key Note: In Ito’s process, drift and variance rate is

dependent on past values of the variable.

Monte Carlo Simulation

We can apply monte-carlo simulation technique to evolve a variable and get
its values for future time intervals. Mont-carlo simulation relies on the
expected probability distribution of the variable that you want to simulate.

Monte carlo is a procedure to produce new

outcomes for a process.

Monte carlo works by sampling random outcomes for the process. In a

nutshell:

1. Time is divided into a large number of intervals

2. Drift and Variance rates of a variable are calculated.

3. A random variable is retrieved from a sample of values. This random

variable needs to follow the same probability distribution as our target
variable. For example, if we believe our variable follows normal distribution
then we need to draw a random variable that also follows normal
distribution.

4. To get the next value of a variable, its current value is multiplied by its
drift rate and added to the product of variance rate, its current value and a
random variable.

This process is Markov in nature because 1. Future

values do not depend on past values and 2. Random
number across time is independent of each other.

When we simulate a variable, we also need to take its correlations with

other variables into account. I will cover correlated variables in my
subsequent articles.

Summary
This article provided an overview of common mathematical concepts
concentrated around stochastic process. These concept are crucial to
understand in machine learning, Dnance and risk management.

Please let me know if you have any feedback.

Statistics Finance Fintech Mathematics Stocks

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WRITTEN BY

Farhad Malik Follow

My personal blog, aiming to explain complex mathematical,

_nancial and technological concepts in simple terms. Contact:
FarhadMalik84@googlemail.com

FinTechExplained Follow

This blog aims to bridge the gap between technologists,

mathematicians and _nancial experts and helps them
understand how fundamental concepts work within each _eld.
Articles

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