Reviewed by Jan 05, 2021| Updated on
Scenario analysis is the method of calculating the expected value of a portfolio after a given period of time, whether there are significant adjustments in the prices of the securities of the portfolio, or key factors, such as interest rate changes.
Scenario analysis as a technique involves calculating various reinvestment levels for expected returns, which are reinvested within the investment horizon. Based on mathematical and statistical principles, the scenario analysis provides a process for estimating shifts in the portfolio value based on the occurrence of different situations, following the principles of "what if" analysis.
These evaluations can be used to examine the amount of risk present in a given investment in relation to a variety of potential events, ranging from highly likely to highly unlikely. An investor can determine whether the level of risk present falls within his comfort zone, depending on the results of the analysis.
Stress testing is one type of scenario analysis that specifically looks to worst-case scenarios. Stress testing is often used to test the resilience of institutions and investment portfolios against possible future critical situations using a computer simulation technique.
The financial industry usually uses such testing to help gauge investment risk and asset adequacy, as well as to assist in evaluating internal processes and controls. Regulators have also required financial institutions in recent years to perform stress tests to ensure the adequacy of their capital holdings and other assets.