Scenario analysis

• a process of analyzing possible future events by considering alternative possible outcomes

• development of scenarios regarding what would likely come to pass if various combinations
of those events did take place
• Also known as a horizon analysis or a total return analysis

• designed to allow improved decision-making by allowing consideration of outcomes and

• Scenarios let you explore how you might behave (or decide) if things are better or worse or
just different.

• Unlike budgeting where you care about who changed what number, scenario analysis is
about understanding what's behind the numbers — the most critical assumptions, volume
and rate impacts, and especially what's driving material changes to the P&L and cash flow.
Financial perspective…
• estimating the expected value of a portfolio after a given period of time,
assuming specific changes in the values of the portfolio's securities or key
factors that would affect security values, such as changes in the interest rate.
• It commonly focuses on estimating what a portfolio's value would decrease
to if an unfavorable event, or the "worst-case scenario", were realized.
• computing different reinvestment rates for expected returns that are
reinvested during the investment horizon.
• a financial institution might attempt to forecast several possible scenarios
for the economy (e.g. rapid growth, moderate growth, slow growth) and it
might also attempt to forecast financial market returns (for bonds, stocks
and cash) in each of those scenarios.
• . In so doing the financial institution seeks to control its own business risk
rather than the client's risk portfolio
• This process is helpful in a number of situations, including
business expansion and investing. Individuals and businesses
alike can benefit from engaging in this type of analysis.
• Geo-political applications
• In politics or geo-politics, scenario analysis involves
modelling the possible alternative paths of a social or
political environment and possibly diplomatic and war risks.
For example, in the recent Iraq War, the Pentagon certainly
had to model alternative possibilities that might arise in the
war situation and had to position materiel and troops
accordingly.
 Using Scenario Analysis for
Risk Management
Scenario analysis is an essential tool for financial risk management and asset allocation.
It can give an important a priori information to a risk or portfolio manager
and helps to control the e®ect of price changes to a portfolio, especially those of
potential market crashes.
One of the most challenging problems in managing the risk of a portfolio or trading
book is to be adequately prepared to potential future market changes.
History may
be one advisor for the future but de¯nitely not the only and sometimes also not
the best one. Nevertheless, empirical price changes can give an important insight
into the joint behaviour of di®erent risk factors under normal market conditions.
Stochastic models may then be applied to describe the movement of future market
prices and used to generate a corresponding set of price scenarios. Event or
crash scenarios could be added to consider non-normal or chaotic market movements.
However, if these scenarios are a good representation of the possible future
price changes, the risk manager or trader may use this information to calculate
risk numbers like expected return, standard deviation or shortfall probability, i.e.
the probability that the return falls below a given benchmark. According to these
numbers a portfolio manager may decide on the detailed structure of his portfolio.
In this article we will use a multi-factor ¯nancial market model to describe the joint
movement of bond and share prices.
 Uses:
• For a business, scenario analysis is very helpful when it comes to making plans for launching a new product or cultivating a
new market of consumers. By identifying various factors that could have an impact on the success of the project, it is possible
to begin creating scenarios that can help project what could happen if certain factors were addressed in specific ways. The
exercise can often lead to anticipating and resolving issues before they ever have the chance to undermine the project, thus
enhancing the chances for success.
• Investors can also make use of scenario analysis when considering various types of investment transactions. For example,
considering what would happen to the value of a given stock if key officers left the company issuing the options, natural
disasters, or even political changes may influence the investor’s course of action. If the scenarios indicate that events with a
high probability of occurring will cause the shares to increase in value, while also indicating that less likely events would have
minimal impact on the stock, there is a good chance that the investor will move forward with the purchase.
• The process of scenario analysis can be used for short-term projects as well as long-term situations. Investors who are seeking
a quick return on an investment can utilize the strategy just as efficiently as someone who is looking for ways to build a
financial portfolio that will generate a modest but consistent return over the years, thus creating a nest egg for retirement. The
key to making the strategy effective is making sure to consider all variables that can be reasonably identified and follow each of
the resulting scenarios to their likely conclusion. Once that has taken place, it is possible to make an informed position in terms
of how to proceed.
• As with many types of financial strategies, the value of scenario analysis is only as good as the information that goes into the
process. Failing to take into account certain probable events increases the risk of making poor decisions, and ultimately losing
money or other resources as a result of the course chosen. At the same time, pursuing scenario analysis with a great deal of
verifiable detail can help make it possible to accurately project future market yields, increase profits, and make the total
returns from the project higher than they would have been otherwise.
• Scenariotypes are selectednext.Scenario development provides managers witha "whatif"analysis. Itallowsthe
managerstomakedifferentassumptionsaboutthefuture andmakedecisionsbasedontheseassumptions.
 AdvantagesofScenarioAnalysis

Management the Range of Outcomes

1. Not only show positive outcomes, but they also make evident the
outcomes which are undesirable to management
2. Multiple scenarios give management an idea of the degree of
uncertainty in the future environment. This may prohibit management
from locking into a Specific environment and it can encourage them to
develop contingency plans and to perform risk analysis.
3.Scenariosgiveinsightsonthebusinessdynamicsoftheorganization.
Althoughtheywillnotprovidemanagerswiththetimingofstructural
changes,theygiveanunderstandingofthebusinessdynamics,trendsto
monitorandrangesofpossiblefutureoutcomes(Huss1988:381).
ScenariosGiveManagementFlexibilityinPlanning.

1.Avarietyofscenariogeneratingproceduresare"user-friendly."The
proceduresrangefrominformaltoformal,andthedegreeofformality canbe
suitedtothesituation(LinnemanandKlein,1985:66).
2.Scenarios can showtheinteractionbetweenvariables,allowingmanagementto
useamoreadaptivemodeinplanning(LinnemanandKlein,1985:66).
3.Scenariosenableanorganizationtodeterminetheir marketpositionwithinthe
operatingenvironment.Theyallowtheorganizationto have anexternalview
insteadofaninternalview,thusemphasizingamarket andcustomer orientation (Huss1988:381).
4.Scenariosare flexible enoughtoallowtheincorporationofotherforecasts.
Techniquessuchaseconometricmodeling,trendanalysisand Delphicanbe used todevelop
ascenario (Linneman andKlein,1985:66).
5.Scenariosintegratenot only quantitativeinputs,butalso qualitativeinputssuch asregulatoryissues
and worldpolitics into theforecastingprocess(Linneman andKlein,1985:66).
6.By testing the effectsofalternativeevents,scenarios promote sensitivity
analysis.Forinstance,theycanbe usedtotesttheeffectoflow probability,
highimpacteventssuchas theassassinationof a worldleaderoranincrease in terroristactivity.
Manyscenariomethodsallowtheseeventstobedepicted usingcomputermodels,whileother
methodsdepend ontheknowledgeofthe development team (Huss1988:381).
TheyEnhancetheHumanResourceAspects of an Organization.
1.Scenariosencouragecommunicationbetweenorganizationaldepartmen
tsby forcingthemtointeracton variousissues.Thoughthe
departmentsmaynot agreeon a particular scenario, they do provide a
basi uponwhichplannersand managementcanevaluate the key
decisions(Huss1988:381)
2.By using groupprocessessuchas theDelphimethodandnominalgroup
technique, scenariosbuildteam spirit and consensus.Theseprocesses
increaseboththeorganizationalcommunicationandthe
understandingthat sharedconcernsaretobe achieved (Huss1988:381).
3.Scenariosgive risetocreativeideasasabyproductofenhanced
organizational communication methods (Huss1988:381).
 DisadvantagesofScenarioAnalysis.Thoughscenarioanalysis has
many
advantages,itstillhas some drawbacks thatneedtobeaddressed,
including the following.
1.Scenariodevelopersmaybeoverconfidentintheirjudgment and may develop scenariosthat
areleastlikelytocounter their ideas.
2.Developersmaybeloverconfidentintheamountofinfluencethey haveover events(Bunnand
Salo,1993:299)
3.Awell-thoughtoutanddetailedscenario can seemmoreprobable tousersthan its
companionscenariosbecauseofthe completenesswith which it is described.In
reality,thescenariosmay have equal probability.To resolve this problem,thepresentationof
scenariosshould beset in a standardformat. For example,each scenario shouldbe
allottedthesame amountoftime,levelof detailandintensityof
investigation(Fischoff1988:337).
4.Amara(1988:390)statesthat managers mustbeawareof information overload.
Sjoberg(1982:350)warnsthat excessive information gatheringmay haveadetrimentaleffecton
thequalityofthe decisionswhile theconfidenceof the decision makersincreases.
5.Schoemaker(1993:209)also identified othernegativeaspectsofthe scenario approach
suchasarelatively steep learningcurve, organizationalcultureshock andthenew challengesof
movingfrommultiple scenarios toone strategy, budgetorplan.