Scenario Analysis: How It Works and Examples

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 take place, such as a change in the interest rate.

Scenario analysis is commonly used to estimate changes to a portfolio's value in response to an unfavorable event and may be used to examine a theoretical worst-case scenario.

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 is simply 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 Example

One type 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 used to help 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 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.

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 can be used in both investment strategy and corporate finance.

While it's a great tool for investors and managers to utilize, scenario analysis is only as good as the assumptions and inputs made by the user.