Enhanced Scenario Analysis
23 Pages Posted: 20 May 2019 Last revised: 15 Jun 2019
Date Written: May 3, 2019
Investors have long relied on scenario analysis as an alternative to mean-variance analysis to help them construct portfolios. Even though mean-variance analysis accounts for all potential scenarios, many investors find it difficult to implement because it requires them to specify statistical features of asset classes which are often unintuitive and difficult to estimate. Scenario analysis, by contrast, requires only that investors specify a small set of potential outcomes as projections of economic variables and assign probabilities to their occurrence. It is, therefore, more intuitive than mean-variance analysis, but it is highly subjective. The authors propose to replace the subjective elements of scenario analysis with a robust statistical process.
Keywords: Covariance matrix, Economic scenarios, Euclidean distance, Financial turbulence, Gradient descent, Mahalanobis distance, Mean reversion, Mean-variance analysis, Multivariate normal distribution, Persistence, Scale independent, Scenario analysis
JEL Classification: C01, C02, C13, C18, C4, C6, G10, G17
Suggested Citation: Suggested Citation