Checklist Description
This checklist describes financial scenario analysis and how it is used to improve decision-making and investment planning.
Definition
Scenario analysis is the process of forecasting the likely outcomes of future events by following a variety of possible scenarios. It is the formalized process of “what if” analysis that in reality has always been part of business decision-making. The objective of scenario analysis is to improve decision-making by analyzing possible outcomes and their implications.
Financial scenario analysis is thought have originated in banks and insurance companies in the 1970s and 1980s, when interest rate volatility began to constitute a threat to balance sheets. Today, financial institutions use scenario analysis in asset liability management and corporate risk management, and it remains the primary tool for analyzing interest rate risk. Businesses use scenario analysis for the analysis of a number of risks.
A financial institution may use scenario analysis to forecast what might happen to the economy by following various paths (e.g. rapid growth, slow growth, slowdown, recession), and what might happen to financial market returns, such as bonds, stocks, or cash, in each of those economic scenarios. The scenarios may have sub-scenarios, and probabilities may be assigned to each. Such analysis will help the institution to determine how to distribute its assets between asset types, and from this it can calculate a scenario-weighted expected return to help demonstrate the attractiveness of the financial environment.
A scenario is usually specified as a set of “paths” that will be determined by risk factors. Typically, in financial matters these risk factors include interest rates, exchange rates, equity prices, commodity prices, and implied volatilities. Outcomes can be modeled mathematically or statistically, and the figures can be put through a spreadsheet program or other modeling software.
Financial scenario analysis usually seeks to estimate a portfolio’s value in a worst-case situation. Different reinvestment rates for expected returns which are then reinvested during the period are calculated using scenario analysis. This may be approached in many ways, but usually the standard deviation of daily or monthly returns on securities is determined, and the value of the portfolio is calculated assuming that each security has given returns two or three standard deviations above or below the average return.
Thus an analyst will have reasonable certainty that the value of a portfolio is unlikely to drop below (or increase above) a certain value during a given time period.
Advantages
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Financial scenario analysis enables a financial institution to manage its own business risk as well as its customers’ portfolio risks.
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It gives a likely range of values for investments.
Disadvantages
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Financial scenario analysis can be a demanding exercise that requires skill and expertise.
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As it is difficult to forecast exactly what the future holds, the actual future outcome may be entirely unexpected and not foreseen in the modeling.
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It is difficult to imagine all possible scenarios and assign probabilities to them.
Action Checklist
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Decide on a subject for scenario planning (e.g. a range of investments).
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Decide whether to group scenarios into subsets.
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Determine the risk factors, list all scenarios, and assign probabilities.
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Decide on a step-horizon (e.g. month, quarter, year).
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Process using your chosen software.
Dos and Don’ts
Do
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Try to define scenarios that are independent of human decisions.
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Identify which random events are most important for the company.
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Consider worst-case scenarios.
Don’t
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Don’t pick events that are unimportant to the company.
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Don’t be limited by the software you use.
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Don’t underestimate the worst possible cases.
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