Scenario Analysis in Forecasting

Industry and Business Risks

Industry and business risks can lead to future outcomes that deviate from expectations. These risks are crucial in the final step of forecasting, where the possibility of different outcomes based on key risk factors is considered, along with their likelihood of occurrence.

Generic risk factors are those that affect all companies but to varying degrees. These include:

• Changes in the business cycle.
• Competition.
• Inflation and deflation.
• Technological developments.

Scenario Analysis

Instead of developing single-point estimate forecasts, analysts create several forecast scenarios that vary based on different outcomes with respect to key risk factors. These scenarios are then compared with other analysts’ forecasts for a company, as well as forecasts implied by current valuations, to make investment decisions.

For instance, scenario analysis can be used to assess the impact of technological developments that threaten to cannibalize demand for an existing product. Technological developments can affect both the demand for a product and the quantity supplied of a product.

For example, when technological changes lead to lower manufacturing costs, the supply curve shifts to the right as suppliers can produce more of the product at the same price. On the other hand, if technological changes result in the development of attractive substitute products, the demand curve shifts to the left.

Question

In scenario analysis, how are different forecast scenarios typically created?

1. By comparing them to historical data.
2. By making single-point estimates.
3. By varying outcomes related to key risk factors.

The correct answer is C.

Scenarios are created from varying outcomes related to key risk factors. Scenario analysis involves developing multiple scenarios, each of which represents a different set of conditions or assumptions, including variations in key risk factors. They are used to explore a range of possible outcomes and assess how different risk factors can influence the outcome being analyzed.

A is incorrect. Scenarios in scenario analysis are not necessarily created directly from historical data, but historical data can serve as an important input and reference point in the process of creating scenarios.

B is incorrect. Scenarios are not typically created from single-point estimates. Scenarios are constructed to consider a range of possible outcomes, and they are characterized by a set of assumptions that deviate from a single-point estimate. The purpose of scenarios is to explore different conditions and uncertainties rather than relying on a single, deterministic forecast.