is one of the most essential topics in finance and a must study for Financial Modeling training. Cash-flows generally come with uncertainty and involve risks. However, there are situations when it is not the same. Thus there can be two faces of cash-flows – Certainty and Uncertainty in this post. Based on these two faces, cash-flows can be classified into Deterministic and Stochastic. Let’s discuss about the same in this post.
When there is no uncertainty related to the future value or timing of a cash-flow, one says that the cash-flows is “Deterministic”
. This means the cash-flow does not have any risk attached to it. Examples of deterministic cash-flows are stated as below.
Examples of Deterministic Cash-Flows
- Government bonds can be assumed to have no risk of default
- Coupons on fixed-income instruments with risk of default
- Any cash-flows those are post-determined such as future cash-flows based on some market interest-rates that are known at the time of projections and so on.
Stochastic is completely opposite to deterministic. A “Stochastic”
cash-flow is a cash-flow that holds some sort of uncertainty. The uncertainty can relate to any aspect relevant to the cash-flow: value, time or anything else that could be relevant. The term stochastic comes from “stochastic process” which is a collection of random variables through time. Each random variable corresponds to the value of a phenomenon observed at a specific point in time. A random variable is a variable that can take different values; each value being given a specific probability.
Types of Random Variables:
Examples of Stochastic Cash-Flows:
- Discrete Random Variables: Some random variables are called discrete when there are finite numbers of values.
- Continuous Random Variables: Some other random variables on the other hand are called continuous because they take their value within some continuum.
- Corporate bonds with risk of default
- Dividend for stocks quoted on a Stock exchange
- Coupons from variable-rate securities
- Cash-flows from Mortgage-backed securities and so on.
These are the most important basics of cash-flows. To know more about cash-flow, you can explore our training courses on Financial Modeling. Simplilearn offers both online and classroom training on Financial Modeling.
Cash-flows can be classified into Deterministic and Stochastic. Learn more about cash flow and improve your expertise in Financial Modeling.
Eshna is a writer at Simplilearn. She has done Masters in Journalism and Mass Communication and is a Gold Medalist in the same. A voracious reader, she has penned several articles in leading national newspapers like TOI, HT and The Telegraph. She loves traveling and photography.