Charta is on Google Play: practise on the go. Get the app
Charta

Explain what scenario analysis contributes when an ERM program is implemented, along with its strengths and weaknesses.

FRM® Part I · Foundations of Risk Management · Enterprise Risk Management and Future Trends · FRM1.FR.8.e

The idea

Scenario analysis assesses what happens to the firm's earnings, capital or liquidity if a specified combination of risk-factor moves occurs, taken from history or built hypothetically by judgement. In ERM it is forward looking, can include events with no precedent, can combine market, credit and liquidity effects, does not depend on estimated distributions or correlations, and is easy to explain to the board. Its weaknesses are subjectivity in choosing and calibrating scenarios, the impossibility of covering all possibilities, anchoring on past crises, and the lack of an objective probability attached to each scenario. A common mistake is to read scenario results as a loss at a confidence level the way VaR is read. Expected loss can be found by assigning subjective probabilities to scenarios, but those probabilities are judgemental. The exam point is complementarity with VaR.

Formulas

Probability-weighted scenario loss

expected loss = p1 × L1 + p2 × L2 + … + pn × Ln

p1, p2, pn
the subjective probability given to each scenario
L1, L2, Ln
the loss in each scenario

The probabilities are management judgement, not estimates, so the result is not a confidence-level loss like VaR.

A practice question

From the question bank, with the reason each wrong option is wrong.

Which is a recognised strength of scenario analysis?

  1. It gives an objective probability for each scenario, which makes the results comparable across firms.Why not: Probabilities are typically subjective or absent; this is a weakness.
  2. It can include events with no historical precedent and does not rely on estimated distributions or correlations. - correct
  3. It guarantees that all possible adverse events are covered, since scenarios span every risk factor.Why not: It cannot cover everything; only a limited set is considered.
  4. It removes the need for management judgement.Why not: Scenario choice and calibration depend heavily on judgement.

The advantage is flexibility: scenarios are forward looking and not tied to history or statistical assumptions.

A harder one

Management assigns subjective probabilities of 60%, 30% and 10% to a mild, a moderate and a severe scenario, with portfolio losses of USD 5 million, USD 20 million and USD 80 million. The probability-weighted expected loss is closest to:

  1. USD 17 million - correct
  2. USD 35 millionWhy not: Takes the simple average of the three losses and ignores the probabilities.
  3. USD 80 millionWhy not: Uses only the severe scenario's loss, ignoring the probabilities.
  4. USD 9 millionWhy not: Omits the severe scenario; the weights must cover all three outcomes.

Expected loss = 0.6 x 5 + 0.3 x 20 + 0.1 x 80 = 3 + 6 + 8 = 17. The weights are management judgement, not statistical estimates.

The hardest tier

A firm runs a scenario in which the equity market falls 25% and yields rise 150 basis points. It holds USD 50 million of equities with a beta of 1.2 and USD 80 million of bonds with a modified duration of 6. Using beta for equities and duration only (ignore convexity), the scenario loss is closest to:

  1. USD 19.7 millionWhy not: Applies a beta of 1.0 to the equities and ignores the stated beta of 1.2.
  2. USD 15.0 millionWhy not: Counts only the equity loss and omits the bond loss from the rise in yields.
  3. USD 87.0 millionWhy not: Unit error: treats 150 basis points as 15 percent when computing the bond loss.
  4. USD 22.2 million - correct

Equity loss = 50 x 1.2 x 0.25 = 15.0; bond loss = 80 x 6 x 0.015 = 7.2; total = 22.2. Mapping risk-factor moves to positions is how scenario losses are calculated.

In the app: 6 practice questions on this outcome, spaced review that brings it back before you forget it.

Start free →

More in Enterprise Risk Management and Future Trends