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Scenario analysis is a process of analyzing possible future events by considering alternative possible outcomes (sometimes called "alternative worlds"). Thus, the scenario analysis, which is a main method of projections, does not try to show one exact picture of the future. Instead, it presents consciously several alternative future developments. Consequently, a scope of possible future outcomes is observable. Not only are the outcomes observable, also the development paths leading to the outcomes. In contrast to prognoses, the scenario analysis is not using extrapolation of the past. It does not rely on historical data and does not expect past observations to be still valid in the future. Instead, it tries to consider possible developments and turning points, which may only be connected to the past. In short, several scenarios are demonstrated in a scenario analysis to show possible future outcomes. It is useful to generate a combination of an optimistic, a pessimistic, and a most likely scenario. Although highly discussed, experience has shown that around three scenarios are most appropriate for further discussion and selection. More scenarios could make the analysis unclear.[1][2]

Principle[edit]

The analysis is designed to allow improved decision-making by allowing consideration of outcomes and their implications.

Scenario analysis can also be used to illuminate "wild cards." For example, analysis of the possibility 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. However, this possibility is usually disregarded by organizations using scenario analysis to develop a strategic plan since it has such overarching repercussions.

Financial applications[edit]

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 determine correlations and 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). It may also perform stress testing, using adverse scenarios.

Depending on the complexity of the problem 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 modeled mathematically/statistically e.g. taking account of possible variability within single scenarios as well as possible relationships between scenarios. In general, one should take care when assigning probabilities to different scenarios as this could invite a tendency to consider only the scenario with the highest probability.[3]

Geopolitical applications[edit]

In politics or geopolitics, 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.

Traditional critique[edit]

While there is utility in weighting hypotheses and branching potential outcomes from them, reliance on scenario analysis without reporting some parameters of measurement accuracy (standard errors, confidence intervals of estimates, metadata, standardization and coding, weighting for non-response, error in reportage, sample design, case counts, etc.) is a poor second to traditional prediction. Especially in “complex” problems, factors and assumptions do not correlate in lockstep fashion. Once a specific sensitivity is undefined, it may call the entire study into question.

It is faulty logic to think, when arbitrating results, that a better hypothesis will obviate the need for empiricism. In this respect, scenario analysis tries to defer statistical laws (e.g., Chebyshev's inequality Law), because the decision rules occur outside a constrained setting. Outcomes are not permitted to “just happen”; rather, they are forced to conform to arbitrary hypotheses ex post, and therefore there is no footing on which to place expected values. In truth, there are no ex ante expected values, only hypotheses, and one is left wondering about the roles of modeling and data decision. In short, comparisons of "scenarios" with outcomes are biased by not deferring to the data; this may be convenient, but it is indefensible.

“Scenario analysis” is no substitute for complete and factual exposure of survey error in economic studies. In traditional prediction, given the data used to model the problem, with a reasoned specification and technique, an analyst can state, within a certain percentage of statistical error, the likelihood of a coefficient being within a certain numerical bound. This exactitude need not come at the expense of very disaggregated statements of hypotheses. R Software, specifically the module “WhatIf,”[4] (in the context, see also Matchit and Zelig) has been developed for causal inference, and to evaluate counterfactuals. These programs have fairly sophisticated treatments for determining model dependence, in order to state with precision how sensitive the results are to models not based on empirical evidence.

See also[edit]

References[edit]

  1. ^ Aaker, David A. (2001). Strategic Market Management. New York: John Wiley & Sons. pp. 108 et seq. ISBN 0-471-41572-3. 
  2. ^ Bea, F.X., Haas, J. (2005). Strategisches Management. Stuttgart: Lucius & Lucius. pp. 279 and 287 et seq. 
  3. ^ The Art of the Long View: Paths to Strategic Insight for Yourself and Your Company, Peter Schwartz, Published by Random House, 1996, ISBN 0-385-26732-0 Google book
  4. ^ "WhatIf: Software for Evaluating Counterfactuals", H Stoll, G King, L Zeng - Journal of Statistical Software, 2006

Further reading[edit]

  • "Learning from the Future: Competitive Foresight Scenarios", Liam Fahey and Robert M. Randall, Published by John Wiley and Sons, 1997, ISBN 0-471-30352-6, Google book
  • "Shirt-sleeve approach to long-range plans.", Linneman, Robert E, Kennell, John D.; Harvard Business Review; Mar/Apr77, Vol. 55 Issue 2, p141

Original courtesy of Wikipedia: http://en.wikipedia.org/wiki/Scenario_analysis — Please support Wikipedia.
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251 news items

 
Actuarial Post
Fri, 27 Jun 2014 03:18:45 -0700

Standard Life Investments, the global investment manager, considers a new approach to scenario analysis. The latest edition of Global Horizons examines in detail a new scenario analysis framework that has been developed by Standard Life Investments to ...
 
Business Wire (press release)
Wed, 23 Jul 2014 07:48:45 -0700

MONTERREY, Mexico--(BUSINESS WIRE)--Mexico's energy reform is a long-term positive for the country, while Comision Federal de Electricidad (CFE) may face margin pressures, according to a new Fitch Ratings sensitivity analysis report. "CFE will remain ...
 
Florida Newswire
Wed, 23 Jul 2014 13:48:45 -0700

ReverseVision continues to improve their software with frequent new innovations building on pioneering capabilities in reverse mortgage interactive graphs, scenario analysis, multi-environment performance analysis and workflow in the origination process.
 
Structured Credit Investor (subscription)
Wed, 23 Jul 2014 03:30:00 -0700

"Ultimately, our scenario analysis shows that the marginally lower repayment rates on high LTV interest-only loans leave some limited tail-risk exposure in UK non-conforming RMBS." Moody's base-case scenario predicts that the cumulative default rate ...
 
Reuters
Tue, 22 Jul 2014 05:33:45 -0700

(Repeat for additional subscribers). July 22 (Reuters) - (The following statement was released by the rating agency). Fitch Ratings has assigned Torque Securitisation (RF) Limited's ZAR250m class A4 notes a 'AAA(zaf)(EXP)' expected rating with Stable ...
 
The Borneo Post
Tue, 22 Jul 2014 09:41:15 -0700

All in, based on its scenario analysis, the research arm's sum-of-parts (SOP) fair values for Muhibbah/KKB are RM3.90 per share/RM2.75 per share,which imply 17 per cent/15 per cent upside from their current share prices.. “Although share prices have ...
 
Wall Street Journal
Fri, 18 Jul 2014 06:52:30 -0700

The Forum's purpose is to examine the main economic and market drivers -- typically through scenario analysis over a 12- to 18-month time horizon -- and to foster debate between the teams managing different asset classes. The three economic scenarios ...
 
Morningstar.com
Fri, 18 Jul 2014 04:03:45 -0700

Acquisitions have been a core component of VF's growth strategy and are likely to continue to be a strategic goal, given their inclusion in the company's 17x17 five-year plan. We have completed a scenario analysis to determine the impact they would ...
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