WEBVTT

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Now it's time to talk about some of
the words that people throw around

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when they do quantitative modelling and so

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being exposed to this vocabulary is
helpful because it will allow you to

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describe to other people more
accurately what you're doing and also

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when you hear about someone else's model,
you'll have a sense of what's going on.

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And so, I'm going to describe
some of these terms here.

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Okay, there's a spectrum out there and

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most models fit on the spectrum somewhere
between empirical and theoretical.

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So an example of a theoretical model
is an option pricing model and

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what I mean there is that by a theoretical
model, is that someone has laid down

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a set of assumptions, they have written
down some relationships and they really

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ask what are the logical consequences
of those assumptions and relationships.
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So there could be assumption
that markets are efficient, and

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then given that assumption,
there are certain logical consequences and

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those logical consequences could be used
for example, to come up with a model for

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pricing, a stock option and so
that's an example of a theoretical model.

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The other end of the spectrum is a model
that is purely based on data and

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that's when I've got a set of
observations and I'm asking myself,

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how can I approximate the underlying
process that generated those observations?

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And so I start with the data and
then I try to back out

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the model as opposed to the theoretical
one where I start with the theory and

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look at the consequences of that theory.

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So an example of a data driven model might
be a set of customers that I have I have,

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I figured out the profitability
of each of those customers and
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now I ask myself the question, what
are the essential characteristics that

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separate out the profitable
from unprofitable customers?

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That would be a useful thing to know,
but my starting point here

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is not some grand theory of how the world
works, my starting point is a spreadsheet

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full of data, the data being
the profitability of my customers.

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There's a set of attributes associated
with those customers, and I'm trying to

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figure out which of the attributes are
associated with profitable customers, so

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that would be an example of
a totally data driven model.

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So, that's essentially the spectrum
where most modellers fit,

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somewhere between empirical and
theoretical.

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You'll find that there are often
arguments between people

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because they lie at different
points on the spectrum.

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My own opinion here is that you
really want to be able to take

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a piece from both of these approaches.

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Additional terms that you will
hear thrown around by people

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who are making models
are deterministic and probabilistic.

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We're going to look at these two
types of models in other modules,

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but just to get started,
what do we mean by deterministic?

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Well, essentially given
a fixed set of inputs,

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the model's always going to give
the identical or same output.

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So here's an example,
you've got $1000, that's the input.

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You're going to invest at a 4% annual
compound interest for two years.

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After two years, given the way
the money is growing, that $1000 is

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always going to turn out to be equal to or
will have grown to $1081.60 and

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it's never going to change,
it's totally deterministic.

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The same input,
always gives the same output, but

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what happens if you took that $1,000 and
rather than putting it in to

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an investment that was growing at 4%,
you bought lottery tickets with it?

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And, I could say well how much is
this $1,000 going to have grown to

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after two years, for example,
after the lottery has happened.

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Well, the answer now is,
it fundamentally depends on whether or

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not one of those lottery
tickets won the lottery or not.

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If none of the tickets won the lottery,

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then you're going to get an output
of zero, all the money disappeared.

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If one of the lottery tickets was
lucky enough to win the lottery,

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you're going to get a very,
very different output.

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And so the output of this process or

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model is probabilistic,
it's what we call a random variable.

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It all depends on whether or
not the lottery was won.

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So that's very different from
the deterministic model.

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And, the term stochastic is often used
as really a synonym for a probabilistic

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model, so you'll see both of those
terms used when there's uncertainty.

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And so those are terms deterministic and
probabilistic.

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More terms.

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The next one is discrete
versus continuous.

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Now, the analogy that I'm going to
use here is the idea of a watch.

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Now, there are two different
sorts of watches, essentially.

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Some watches are digital, and
others are what we call analog.
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And so a digital watch only can show
you specific times because it has

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the given or finite number of numbers
appearing on the face and so,

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there's some inherent resolution beyond
which you can't go in telling the time.

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On the other hand,
if you have an analog watch,

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that's one where the hands
are physical and

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sweep out the time,
then it can pick up any time

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possible because the hands have to
go through every single number.

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That's the idea of something
that's continuous.

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So just as we have digital and analog,

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we're going to have in our modelling,
the same concept happening.

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In the modelling world,
we would call them discrete or continuous.

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So discrete processes are characterized
by jumps in distinct values just like
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the digital watch, the numbers
jump from one to another whereas

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continuous processes tend to be
much smoother and more formally,

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you can get an infinite number of
values happening in any fixed interval.

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And so going back to the watch here,
you will see every possible time presented

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on the analog watch between say,
12 o'clock and 1 o'clock,

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because the hands are going to sweep out
every single time within that period.

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And so, some models will be discrete and
others will be continuous and

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it's one of the choices that
the modeller gets to make.

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Now when you do spreadsheets,

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you're typically taking a rather
discrete approach to the world.

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When you think of mat
continuous variables,

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it tends to be a little more
mathematical in nature.
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Final terms that we want to talk
about are static and dynamic models.

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So, static models are those that are
really trying to capture a single snapshot

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of a business process and so
here's an example of a static model.

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Given a website's installed software base,

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what are the chances that
it is compromised today?

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I'm just trying to make a statement
about this single period in time.

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By contrast, a dynamic model is much
more about an evolution of a process and

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it's the evolution that is of interest
that we are trying to understand.

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And these dynamic models typically capture
a business process moving from state

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to state, and we model
the dynamics of those transitions.

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So here's an example, what I would
think of as a dynamic model and

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this would be a sort of question
that someone who was a public policy
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individual would be interested in,
or an economist.

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So given a person's participation in a job
training program, how long is it until

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he or she finds a job and then once they
find one, how long can they keep it?

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And so I'm thinking here that
a person's participation in the labor

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market goes through a set of states.

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Sometimes they're unemployed, and
sometimes they're employed, and

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they can go from employed back to
unemployed again, potentially.

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And so we'd be interested in modeling
the transition through these states,

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and that would be the idea of a dynamic
as opposed to a static model.

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So there's a whole set of
terminology that I've gone through

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that is associated with modelling.

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That's what I call the lexicon of models
and it's not like you can only have one of
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these things going on in terms of the
language, you could clearly have something

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like a static probabilistic,
discrete time model.

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And we're going to see one of those and
it's termed a mark of chain later on.

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So, there's our lexicon.