Scenario within Scenario Analysis

From Open Risk Manual

Definition

Scenario within Scenario Analysis is an approach used in the context of Risk Management to explore future developments that depend crucially on some uncertaint future factor that cannot meaningfully captured by an assumption.

Methodology

For any given scenario that starts at the current time and postulates the realization of some risk factors at future times, a set of new scenarios "branches off" at a future time point, exploring alternative realizations from that point on. The process can be repeated as required (and if tractable to implement).

An important simplification emerges when it can be assumed that realizations of risk factors span a finite set of states (See Recombining Trees).

Usage

  • The pricing of option contracts with early exercise features
  • The evaluation of future liabilities conditional on various market developments
  • In the context of Credit Risk, scenario within scenario analysis is a more elaborate form of Stress Testing.

See Also


References