What Is Scenario Analysis?
Scenario analysis is the process of 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 such as interest rate variations.
Scenario analysis is commonly used to estimate changes to a portfolio’s value in response to unfavorable events and may be used to examine a theoretical worst-case scenario.
Key Takeaways
- Scenario analysis is the process of estimating the expected value of a portfolio after a given change in the values of key factors takes place.
- Both likely scenarios and unlikely worst-case events can be tested in this fashion—often relying on computer simulations.
- Scenario analysis can apply to investment strategy as well as corporate finance.
How Scenario Analysis Works
As a technique, scenario analysis involves computing different reinvestment rates for expected returns that are reinvested within the investment horizon.
Based on mathematical and statistical principles, scenario analysis provides a process to estimate shifts in the value of a portfolio based on the occurrence of different situations—referred to as scenarios—following the principles of “what if” analysis, or sensitivity analysis. Sensitivity analysis assesses how different values of an independent variable affect a dependent variable under specific conditions.
These assessments can be used to examine the amount of risk present within a given investment as related to a variety of potential events, ranging from highly probable to highly improbable. Depending on the results of the analysis, an investor can determine if the level of risk present falls within their comfort zone. Scenario analysis is only as good as the inputs and assumptions made by the analyst.
Scenario Analysis Example
One method of scenario analysis that looks specifically at worst-case scenarios is stress testing. Stress testing is often employed using a computer simulation technique to test the resilience of institutions and investment portfolios against possible future critical situations. Such testing is customarily used by the financial industry to help gauge investment risk and the adequacy of assets.
Stress testing is also utilized to evaluate internal processes and controls. In recent years, regulators have also required financial institutions to carry out stress tests to ensure their capital holdings and other assets are adequate.
Scenario Analysis in Different Situations
There are many different ways to approach scenario analysis.
Scenario Analysis and Investment Strategy
A common method is to determine the standard deviation of daily or monthly security returns and then compute what value is expected for the portfolio if each security generates returns that are two or three standard deviations above and below the average return. This way, an analyst can have a reasonable amount of certainty regarding the change in the value of a portfolio during a given time period by simulating these extremes.
Scenarios being considered can relate to a single variable, such as the relative success or failure of a new product launch, or a combination of factors, such as the results of the product launch combined with possible changes in the activities of competitor businesses. The goal is to analyze the results of the more extreme outcomes to determine investment strategy.
Scenario Analysis in Personal Finance
The same process used for examining potential investment scenarios can be applied to various other financial situations in order to examine value shifts based on theoretical scenarios. On the consumer side, a person can use scenario analysis to examine the different financial outcomes of purchasing an item on credit, as opposed to saving the funds for a cash purchase. Additionally, a person can look at the various financial changes that may occur when deciding whether to accept a new job offer.
Scenario Analysis in Corporate Finance
Businesses can also use scenario analysis to analyze the potential financial outcomes of certain decisions, such as selecting one of two facilities or storefronts from which the business could operate. This analysis could include considerations such as the difference in rent, utility charges, and insurance or any benefit that may exist in one location but not the other.
What Are the Advantages of Scenario Analysis?
The biggest advantage of scenario analysis is that it acts as an in-depth examination of all possible outcomes. Due to this thorough examination, it allows managers to test decisions, understand the potential impact of specific variables, and identify potential risks.
What Are the Disadvantages of Scenario Analysis?
The main disadvantage of scenario analysis is simple: incorrect assumptions can lead to models that are significantly inaccurate—often summarized as “garbage in, garbage out.” Scenario analysis is also susceptible to biases of the user and tends to rely heavily on historical data.
What Is Scenario Analysis in Risk Management?
Scenario analysis involves a thorough look at a wide range of possible outcomes—including those on the downside. This allows risk managers to identify, prepare for, and manage risk exposures.
What Is Scenario Analysis in Strategic Management?
Scenario analysis can be applied to almost any managerial decision, particularly those related to competitive strategy. For example, scenario analysis allows managers to test strategic proposals—such as whether or not to acquire a smaller competitor—and determine how it will perform under different conditions.
What Is the Difference Between Scenario Analysis and Sensitivity Analysis?
Scenario analysis looks at a wide range of possible outcomes, but it analyzes the effect of manipulating all variables simultaneously. The result is typically a base-case scenario, a best-case scenario, and a worst-case scenario.
On the other hand, sensitivity analysis assesses the impact of changing just one variable at a time.
The Bottom Line
Scenario analysis is the process of estimating the expected value of a portfolio after manipulating a number of key variables. The method is useful in both investment strategy and corporate finance.
While it’s a valuable tool for investors and managers, the effectiveness of scenario analysis relies significantly on the accuracy of assumptions and inputs provided by the user.
Related Terms: Portfolio, Sensitivity Analysis, Standard Deviation, Stress Testing, Risk Management.
References
- Board of Governors of the Federal Reserve System. “Stress Tests”.
