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What Is A Scenario Analysis

Scenario analysis is a formal tool used to model the likelihood of various future scenarios and their potential outcomes. It helps measure the expected value of investments by combining probability distributions with expected returns. One common scenario analysis method determines potential portfolio values under high and low security returns above and below the average. For example, an analysis may consider interest rate scenarios where rates fall, remain static, or increase to project their impact on portfolio values over time. Scenario analysis allows analysts to plan for worst-case scenarios and quantify potential costs to inform risk management and business strategies.

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Rahul Baid
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156 views

What Is A Scenario Analysis

Scenario analysis is a formal tool used to model the likelihood of various future scenarios and their potential outcomes. It helps measure the expected value of investments by combining probability distributions with expected returns. One common scenario analysis method determines potential portfolio values under high and low security returns above and below the average. For example, an analysis may consider interest rate scenarios where rates fall, remain static, or increase to project their impact on portfolio values over time. Scenario analysis allows analysts to plan for worst-case scenarios and quantify potential costs to inform risk management and business strategies.

Uploaded by

Rahul Baid
Copyright
© Attribution Non-Commercial (BY-NC)
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as DOCX, PDF, TXT or read online on Scribd
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Businesses have always planned for ³what if´ scenarios²and based


theirdecision-making on likely future events. Scenario analysis is simply a
formal tool to model the likelihood of various scenarios and their outcomes.
Scenario analysis has been widely used in asset management and risk
management since the 1970s, to analyze interest rate risks. However, it
can be applied to a wide set of corporate and financial activities, including
equity prices, exchange rates, commodity prices, and volatility of prices.


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Scenario analysis helps companies and investors to measure the expected
valueof an investment. By combining this information with probability,
analysts can make highly accurate predictions about the likelihood of
realizing the expected value. Comparing the probability distribution of an
event is equivalent to calculating the risk of an investment and important for
the same reason²it allows you to make better decisions about business
and financial investments.

There are many different approaches to scenario analysis, but one


common method is to determine the high/low spread and standard
deviation from daily or monthly returns, then compute the value of the
portfolio if each security generated returns two or three basis points above
and below this average.
This method means the investor or company can have reasonable certainty
that the value of a portfolio will remain within expected parameters over a
given period of time.


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º typical use of scenario analysis would be to consider what happens to
the value of a security if interest rates fell, remained static, or increased.

The first step is to consider all the possible outcomes, or paths, that will be
taken by relevant risk factors (in this case, interest rates). Each potential
outcome is considered over the same time period. In the simple example
below, we can see all the relevant outcomes that might be affected by a
100 basis point fall in interest rates, followed by 24 months of static rates:

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Once you have identified the scenario, the next step is to project what
happens for each of these rates at the given point in time. This
extrapolation may be relatively simple, showing the cost of debt in each
scenario, or might be more complex²for example, by incorporating other
financial data to produce a cash flow forecast, or value at risk metric.
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à Scenario analysis allows analysts to plan for their ³worst-case scenario.´
Being able to quantify the potential costs of a possible outcome is vital
in risk management and forming business strategy. Scenario planning can
be highly detailed, and customized to accommodate any number of
variables, such as the flattening of the yield curve or narrowing spreads.
à One advantage of scenario analysis is that it is simple to use and very
flexible. It can address almost any present or future risk, and can anticipate
the impact of future business decisions. However, its major drawback is
that it can only consider the impact of risks that are anticipated²outputs
are entirely limited to paths suggested by the user, and so if you overlook a
risk, it will not be calculated.
à It is also important to remember that if scenario analysis is based on
probability, there is still a potential that the low and high extreme values
could occur. This is why scenario analysis is often run alongside risk
analysis to determine whether these potential risks are within acceptable
tolerance levels.
à When dealing with complex scenarios over multiple time periods and
involving many possible outcomes (such as the impact on 1,000 clients of
100 differentinterest rate permutations) scenario analysis can be extremely
cumbersome, generating large and complex tables. In such instances,
duration analysis can provide more user-friendly analysis.
à ºnother alternative is to use scenario analysis and the Monte Carlo
method, to calculate results based on a large number of random scenarios.
This approach is sometimes also referred to as ³simulation analysis.´

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