What is Scenario Analysis?
Scenario analysis is the process of estimating the expected value of a portfolio after a specific period of time, making the assumption that specific changes in the values of the portfolio’s securities or key factors take place (i.e. interest rate change). It is mostly used to estimate any change in portfolio value when faced with an unfavourable event. It can be used to examine a worst-case scenario.
The technical side of scenario analysis involves computing different reinvestment rates for expected returns that are reinvested during the investment horizon. Scenario analysis estimates shifts in portfolio value based on the occurrence of different situations, known as scenarios, following the principles of ‘what if” analysis.
These assessments can be used to determine the level of risk present within a given investment as related to a variety of potential events. Depending on the analysis results, an investor can decide whether the level of risk associated with the portfolio is something he wants to pursue.
Scenario Analysis and Investment Strategy
Amongst the many approaches to scenario analysis, one of the most commonly used methods is to determine the standard deviation of daily or monthly security returns and then calculate the expected value if each security generates returns that are two or three standard deviations above and below the average return. Using this method allows analysts to gain a reasonable amount of certainty regarding the change in the value of a portfolio during a specific time period, by simulating these extremes.
Scenarios 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 product launch results combined with possible changes in the activities of competitor businesses. The aim is to analyse the results if the more extreme outcomes to determine investment strategy.
Scenario Analysis in Finance
The process used in examining potential investment scenarios can also be applied to various other financial situations to examine value shifts based on theoretical scenarios. A consumer can use scenario analysis to calculate the different financial outcomes of purchasing an item on credit. One can also use it to look at the various financial changes that can occur when deciding whether to accept a new job offer.
Scenario analysis can be used by businesses to analyse the potential financial outcomes of certain decisions. This can include considerations such as the difference of rent, insurance etc. that may exist in one location but not the other.
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