What is Scenario Analysis?
Scenario analysis is a method of evaluating potential future risk factors and alternative outcomes. It assesses the impact of extreme but plausible scenarios on a given portfolio/ financial position of an institution/system, using sophisticated modelling techniques and typically incorporating macroeconomic variables.
A typical method compares a best-case scenario to a worst-case scenario, which shocks variables to their extreme known values. This process factors in the potential impact of several categories of risk. It influences risk manager decision making by attempting to put a value on an otherwise qualitative concept (i.e., what-if analysis).
Example of Scenario Analysis
In this approach, we define the scenarios by looking at the dispersion of variables. In this approach, scenarios may be multiples of the variables’ standard deviation increase or decrease. In this approach, if there is a distributional assumption for the variable, we can also attach probabilities for deviations. One specific example of scenario analysis is to test the portfolio for the scenario of equity market falls during the financial crisis 2008-09 and see its impact on the bank’s profitability and capital adequacy.
Why is Scenario Analysis a vital tool?
Scenario Analysis allows managers to navigate a path between the illusory certainty of a single forecast and the perplexing immobility that often occurs during chaotic times. They enable a strategy to be built on a sophisticated grasp of probabilities that maximises the odds of the desired outcome when successfully executed.