An investor with some (remaining) exposure to Greece, Spain or Italy would agree that we live in uncertain times. Predicting the future is a rather futile exercise, in response pension funds and investment managers are shifting towards the use of scenarios. Van Notten wrote a very instructive chapter in an OECD Study on the use of scenarios. The word scenario has four different uses:
- Sensitivity analysis, whether in cash flow management, risk assessment, or project management.
- Contingency plan defining who is to do what during a particular event as used in military or civil emergency planning.
- Contingency plan but applied to decision-making in corporate or public policy.
- Scenarios as a more exploratory tool so that a scenario is less a strategy and more a coherently structured speculation, of interest for education.
On one point there is consensus: it is not a prediction or forecast. Pierre Wack, an executive at Royal Dutch who pioneered scenario planning, finds that “Forecasts are not always wrong; more often than not, they can be reasonably accurate. And that makes them so dangerous, They are usually constructed on the assumption that tomorrow’s world will be much like today’s […] forecasts will fail when they are needed most: in anticipating major shifts in the business environment that make whole strategies obsolete. […] The better approach, I believe, is to accept uncertainty, try to understand it, and make it part of our reasoning.”
Characteristics inherent in the various definitions of scenario’s include that they are: hypothetical, causally coherent, internally consistent, and/or descriptive. A definition that covers many of the characteristics proposed by others is: “Scenarios are consistent and coherent descriptions of alternative hypothetical futures that reflect different perspectives on past, present, and future developments, which can serve as a basis for action.” (Van Notten, 2005)
Scenario analysis is closely related to sensitivity analysis (Culp, 2000): “In scenario analysis, the firm considers a specific market price or interest rate scenario (possibly across many prices and rates) and then uses models to re-price the assets and liabilities of an exposures (p.329). “ This suggests two types of scenarios:
- Scenarios with a short-term horizon, where a number of specific market, interest or other price influencing factors are examined, as a sort of sensitivity analysis or stress test.
- Scenarios with a long-term horizon, where economic scenarios are developed based (combinations) of different economic paradigms. One economic paradigm states that monetary economy growth does not stimulate job growth (Stagflation); another that consumer and firms procrastinate spending structurally (Deflation),
How would a short-term scenario work out? Culp (p. 426) gives an example where the case balances of a financial organization are exposed to a situation in which adverse liquidity shocks occur at the same time:
- Securities stop paying interest and dividends
- Letters of credit and sort-term funding guarantees are revoked
- Putable debt is redeemed
- Repos and derivatives counterparties calls for additional collateral
- Swaps, forwards and futures requires substantial margin
Several pension funds have considered the “euro breakdown” scenario, when some countries leave the Eurozone. What will happen to the counterparty – will they be paid in euros? How will stock markets react? Will unwinding lead to reallocations in equity portfolios (in an unintended way)
Having covered the theoretical base, the question remains on how to deploy scenarios in a practical way. The organization could examine commonalities in strategies and prepare beforehand, or use it to gain experience to act when events develop in an unexpected way. Three uses come to mind, which will be dealt with in a follow up blog:
- Short-term scenario to train the board on how to react as an organization and management team.
- Early adaptive strategy development. While scenarios are not meant for prediction, the organization can develop a set of early warning signals to assess if the economic environment is changing, and the base case for the investment policy is no longer valid.
- Long-term policy making. This has been the classical approach applied in Asset Liability Management studies, where scenario’s are condensed to a set of quantitative parameters.
Culp, The Risk Management Process, Wiley Finance, 2001
 Wack, Pierre. 1985. Scenario’s: Uncharted Waters Ahead. Harvard Business Review. No 85516, September-October 1985, pp. 73-89
 Christopher L. Culp, The Risk Management Process, published by Wiley