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Scenario analysis

From Academic Kids

Scenario analysis is a process of analysing possible future events by considering alternative possible outcomes (scenarios). The analysis is designed to allow improved decision-making by allowing more complete consideration of outcomes and their implications.

For example, in economics and finance, 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. It might consider sub-sets of each of the possibilities. It might further seek to assign probabilities to the scenarios (and sub-sets if any). Then it will be in a position to consider how to distribute assets between asset types (i.e. asset allocation); the institution can also calculate the scenario-weighted expected return (which figure will indicate the overall attractiveness of the financial environment).

Depending on the complexity of the financial environment, in economics and finance scenario analysis can be a demanding exercise. It can be difficult to foresee what the future holds (e.g. the actual future outcome may be entirely unexpected), i.e. to foresee what the scenarios are, and to assign probabilities to them; and this is true of the general forecasts never mind the implied financial market returns. The outcomes can be modelled mathematically/statistically e.g. taking account of possible variability within single scenarios as well as possible relationships between scenarios.

Financial institutions can take the analysis further by relating the asset allocation that the above calculations suggest to the industry or peer group disposition of assets. In so doing the financial institution seeks to control its business risk rather than the client's portfolio risk.

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. The difficulty of such forecasting is highlighted in that case by the fact that it is arguable the Pentagon failed to foresee the lawlessness and insecurity of the post-war situation and the level of hostility shown towards the occupying forces.

In other areas scenario analysis can be important and illuminating. For example, analysis of the probability of the earth being struck by a large celestial object (a meteor) suggests that whilst the probability is low, the damage inflicted is so high that the event is much more important (threatening) than the low probability (in any one year) alone would suggest.

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