Financial Terms Stochastic

# Definition of Stochastic

## Stochastic

Involving or containing a random variable or variables; involving
chance or probability.

# Related Terms:

## Stochastic models

Liability-matching models that assume that the liability payments and the asset cash flows
are uncertain. Related: Deterministic models.

## Deterministic models

Liability-matching models that assume that the liability payments and the asset cash
flows are known with certainty. Related: Compare stochastic models

## Arbitrage-free option-pricing models

Yield curve option-pricing models.

## Extrapolative statistical models

models that apply a formula to historical data and project results for a
future period. Such models include the simple linear trend model, the simple exponential model, and the
simple autoregressive model.

## Yield curve option-pricing models

models that can incorporate different volatility assumptions along the
yield curve, such as the Black-Derman-Toy model. Also called arbitrage-free option-pricing models.

## percentage of sales models

Planning model in which sales forecasts are the driving variables and most other variables are
proportional to sales.

## NPV (net present value of cash flows)

Same as PV, but usually includes a subtraction for an initial cash outlay.

## PV (present value of cash flows)

the value in todayâ€™s dollars of cash flows that occur in different time periods.
present value factor equal to the formula 1/(1 - r)n, where n is the number of years from the valuation date to the cash flow and r is the discount rate.
For business valuation, n should usually be midyear, i.e., n = 0.5, 1.5, . . .

## Acquisition of assets

A merger or consolidation in which an acquirer purchases the selling firm's assets.

## Arbitrage-free option-pricing models

Yield curve option-pricing models.

## Asset

Any possession that has value in an exchange.

## Asset/equity ratio

The ratio of total assets to stockholder equity.

## Asset/liability management

Also called surplus management, the task of managing funds of a financial
institution to accomplish the two goals of a financial institution:
1) to earn an adequate return on funds invested, and
2) to maintain a comfortable surplus of assets beyond liabilities.

## Asset activity ratios

Ratios that measure how effectively the firm is managing its assets.

## Asset allocation decision

The decision regarding how an institution's funds should be distributed among the
major classes of assets in which it may invest.

## Asset-backed security

A security that is collateralized by loans, leases, receivables, or installment contracts
on personal property, not real estate.

## Asset-based financing

Methods of financing in which lenders and equity investors look principally to the
cash flow from a particular asset or set of assets for a return on, and the return of, their financing.

## Asset classes

Categories of assets, such as stocks, bonds, real estate and foreign securities.

## Asset-coverage test

A bond indenture restriction that permits additional borrowing on if the ratio of assets to
debt does not fall below a specified minimum.

## Asset for asset swap

Creditors exchange the debt of one defaulting borrower for the debt of another
defaulting borrower.

## Asset pricing model

A model for determining the required rate of return on an asset.

## Asset substitution

A firm's investing in assets that are riskier than those that the debtholders expected.

## Asset substitution problem

Arises when the stockholders substitute riskier assets for the firm's existing
assets and expropriate value from the debtholders.

## Asset swap

An interest rate swap used to alter the cash flow characteristics of an institution's assets so as to
provide a better match with its iabilities.

## Asset turnover

The ratio of net sales to total assets.

## Asset pricing model

A model, such as the Capital asset Pricing Model (CAPM), that determines the required
rate of return on a particular asset.

## Assets

A firm's productive resources.

## Assets requirements

A common element of a financial plan that describes projected capital spending and the
proposed uses of net working capital.

## Balance of payments

A statistical compilation formulated by a sovereign nation of all economic transactions
between residents of that nation and residents of all other nations during a stipulated period of time, usually a
calendar year.

## Base probability of loss

The probability of not achieving a portfolio expected return.

## Capital asset pricing model (CAPM)

An economic theory that describes the relationship between risk and
expected return, and serves as a model for the pricing of risky securities. The CAPM asserts that the only risk
that is priced by rational investors is systematic risk, because that risk cannot be eliminated by diversification.
The CAPM says that the expected return of a security or a portfolio is equal to the rate on a risk-free security

## Cash

The value of assets that can be converted into cash immediately, as reported by a company. Usually
includes bank accounts and marketable securities, such as government bonds and Banker's Acceptances. cash
equivalents on balance sheets include securities (e.g., notes) that mature within 90 days.

## Cash budget

A forecasted summary of a firm's expected cash inflows and cash outflows as well as its
expected cash and loan balances.

## Cash and carry

Purchase of a security and simultaneous sale of a future, with the balance being financed
with a loan or repo.

## Cash and equivalents

The value of assets that can be converted into cash immediately, as reported by a
company. Usually includes bank accounts and marketable securities, such as government bonds and Banker's
Acceptances. cash equivalents on balance sheets include securities (e.g., notes) that mature within 90 days.

## Cash commodity

The actual physical commodity, as distinguished from a futures contract.

## Cash conversion cycle

The length of time between a firm's purchase of inventory and the receipt of cash
from accounts receivable.

## Cash cow

A company that pays out all earnings per share to stockholders as dividends. Or, a company or
division of a company that generates a steady and significant amount of free cash flow.

## Cash cycle

In general, the time between cash disbursement and cash collection. In net working capital
management, it can be thought of as the operating cycle less the accounts payable payment period.

## Cash deficiency agreement

An agreement to invest cash in a project to the extent required to cover any cash
deficiency the project may experience.

## Cash delivery

The provision of some futures contracts that requires not delivery of underlying assets but
settlement according to the cash value of the asset.

## Cash discount

An incentive offered to purchasers of a firm's product for payment within a specified time
period, such as ten days.

## Cash dividend

A dividend paid in cash to a company's shareholders. The amount is normally based on
profitability and is taxable as income. A cash distribution may include capital gains and return of capital in

## Cash equivalent

A short-term security that is sufficiently liquid that it may be considered the financial
equivalent of cash.

## Cash flow

In investments, it represents earnings before depreciation , amortization and non-cash charges.
Sometimes called cash earnings. cash flow from operations (called funds from operations ) by real estate and
other investment trusts is important because it indicates the ability to pay dividends.

## Cash flow after interest and taxes

Net income plus depreciation.

## Cash flow coverage ratio

The number of times that financial obligations (for interest, principal payments,
preferred stock dividends, and rental payments) are covered by earnings before interest, taxes, rental
payments, and depreciation.

## Cash flow from operations

A firm's net cash inflow resulting directly from its regular operations
(disregarding extraordinary items such as the sale of fixed assets or transaction costs associated with issuing
securities), calculated as the sum of net income plus non-cash expenses that were deducted in calculating net
income.

## Cash flow matching

Also called dedicating a portfolio, this is an alternative to multiperiod immunization in
which the manager matches the maturity of each element in the liability stream, working backward from the
last liability to assure all required cash flows.

## Cash flow per common share

cash flow from operations minus preferred stock dividends, divided by the
number of common shares outstanding.

## Cash flow time-line

Line depicting the operating activities and cash flows for a firm over a particular period.

## Cash-flow break-even point

The point below which the firm will need either to obtain additional financing
or to liquidate some of its assets to meet its fixed costs.

## Cash management bill

Very short maturity bills that the Treasury occasionally sells because its cash
balances are down and it needs money for a few days.

## Cash markets

Also called spot markets, these are markets that involve the immediate delivery of a security
or instrument.
Related: derivative markets.

## Cash offer

A public equity issue that is sold to all interested investors.

## Cash ratio

The proportion of a firm's assets held as cash.

## Cash settlement contracts

Futures contracts, such as stock index futures, that settle for cash, not involving
the delivery of the underlying.

## Cash transaction

A transaction where exchange is immediate, as contrasted to a forward contract, which
calls for future delivery of an asset at an agreed-upon price.

## Cash-equivalent items

Temporary investments of currently excess cash in short-term, high-quality
investment media such as treasury bills and Banker's Acceptances.

## Cash-surrender value

An amount the insurance company will pay if the policyholder ends a whole life
insurance policy.

## Cashout

Refers to a situation where a firm runs out of cash and cannot readily sell marketable securities.

## Certainty equivalent

An amount that would be accepted in lieu of a chance at a possible higher, but
uncertain, amount.

## Clearing House Automated Payments System (CHAPS)

A computerized clearing system for sterling funds
that began operations in 1984. It includes 14 member banks, nearly 450 participating banks, and is one of the
clearing companies within the structure of the Association for Payment Clearing Services (APACS).

## Clearing House Interbank Payments System (CHIPS)

An international wire transfer system for high-value
payments operated by a group of major banks.

## Combination matching

Also called horizon matching, a variation of multiperiod immunization and cash
flow matching in which a portfolio is created that is always duration matched and also cash-matched in the
first few years.

## Contingent pension liability

Under ERISA, the firm is liable to the plan participants for up to 39% of the net
worth of the firm.

## Continuous random variable

A random value that can take any fractional value within specified ranges, as
contrasted with a discrete variable.

## Coupon payments

A bond's interest payments.

## Cumulative probability distribution

A function that shows the probability that the random variable will
attain a value less than or equal to each value that the random variable can take on.

## Current assets

Value of cash, accounts receivable, inventories, marketable securities and other assets that
could be converted to cash in less than 1 year.

## Discounted cash flow (DCF)

Future cash flows multiplied by discount factors to obtain present values.

## Discrete random variable

A random variable that can take only a certain specified set of discrete possible
values - for example, the positive integers 1, 2, 3, . . .

## Discretionary cash flow

cash flow that is available after the funding of all positive NPV capital investment
projects; it is available for paying cash dividends, repurchasing common stock, retiring debt, and so on.

## Dynamic asset allocation

An asset allocation strategy in which the asset mix is mechanistically shifted in
response to -changing market conditions, as in a portfolio insurance strategy, for example.

## Endogenous variable

A value determined within the context of a model.

## Equivalent annual cash flow

Annuity with the same net present value as the company's proposed investment.

## Exact matching

A bond portfolio management strategy that involves finding the lowest cost portfolio
generating cash inflows exactly equal to cash outflows that are being financed by investment.

## Exchange of assets

Acquisition of another company by purchase of its assets in exchange for cash or stock.

## Exogenous variable

A variable whose value is determined outside the model in which it is used. Also called
a parameter.

## Expected future cash flows

Projected future cash flows associated with an asset of decision.

## Extrapolative statistical models

models that apply a formula to historical data and project results for a
future period. Such models include the simple linear trend model, the simple exponential model, and the
simple autoregressive model.

## Financial assets

Claims on real assets.

## Fixed asset

Long-lived property owned by a firm that is used by a firm in the production of its income.
Tangible fixed assets include real estate, plant, and equipment. Intangible fixed assets include patents,

## Fixed asset turnover ratio

The ratio of sales to fixed assets.

## Free cash flows

cash not required for operations or for reinvestment. Often defined as earnings before
interest (often obtained from operating income line on the income statement) less capital expenditures less the
change in working capital.

## General cash offer

A public offering made to investors at large.

## Incremental cash flows

Difference between the firm's cash flows with and without a project.

## Inflation uncertainty

The fact that future inflation rates are not known. It is a possible contributing factor to
the makeup of the term structure of interest rates.

## Intangible asset

A legal claim to some future benefit, typically a claim to future cash. Goodwill, intellectual

## Interest payments

Contractual debt payments based on the coupon rate of interest and the principal amount.

## Lag response of prepayments

There is typically a lag of about three months between the time the weighted
average coupon of an MBS pool has crossed the threshold for refinancing and an acceleration in prepayment
speed is observed.

## Ledger cash

A firm's cash balance as reported in its financial statements. Also called book cash.

## Liability

A financial obligation, or the cash outlay that must be made at a specific time to satisfy the
contractual terms of such an obligation.

## Liability funding strategies

Investment strategies that select assets so that cash flows will equal or exceed
the client's obligations.

## Liability swap

An interest rate swap used to alter the cash flow characteristics of an institution's liabilities so
as to provide a better match with its assets.

## Limited liability

Limitation of possible loss to what has already been invested.

## Limited-liability instrument

A security, such as a call option, in which the owner can only lose his initial
investment.

## Liquid asset

asset that is easily and cheaply turned into cash - notably cash itself and short-term securities.

## Long-term assets

Value of property, equipment and other capital assets minus the depreciation. This is an
entry in the bookkeeping records of a company, usually on a "cost" basis and thus does not necessarily reflect
the market value of the assets.

## Limitation on asset dispositions

A bond covenant that restricts in some way a firm's ability to sell major assets.

## Limited-liability instrument

A security, such as a call option, in which the owner can only lose his initial investment.

## Matching concept

The accounting principle that requires the recognition of all costs that are associated with
the generation of the revenue reported in the income statement.

## Net asset value (NAV)

The value of a fund's investments. For a mutual fund, the net asset value per share
usually represents the fund's market price, subject to a possible sales or redemption charge. For a closed end
fund, the market price may vary significantly from the net asset value.

## Net assets

The difference between total assets on the one hand and current liabilities and noncapitalized longterm
liabilities on the other hand.

## Net cash balance

Beginning cash balance plus cash receipts minus cash disbursements.