Enhanced Scenario Analysis

Posted: 20 May 2019 Last revised: 30 Apr 2020

See all articles by Megan Czasonis

Megan Czasonis

State Street Corporate

Mark Kritzman

Windham Capital Management

Baykan Pamir

State Street Associates

David Turkington

State Street Associates

Date Written: May 3, 2019

Abstract

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. In this article, the authors propose to replace the subjective elements of scenario analysis with a robust statistical process. They use a multivariate measure of statistical distance to estimate probabilities of prospective scenarios. Next, they construct portfolios that maximize utility for investors with different risk preferences. Lastly, the authors introduce a procedure for minimally modifying scenarios in order to render them consistent with one’s pre-specified views about their probabilities of occurrence.

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

Czasonis, Megan and Kritzman, Mark and Pamir, Baykan and Turkington, David, Enhanced Scenario Analysis (May 3, 2019). MIT Sloan Research Paper No. 5774-19, Available at SSRN: https://ssrn.com/abstract=3389977 or http://dx.doi.org/10.2139/ssrn.3389977

Megan Czasonis

State Street Corporate ( email )

1 Lincoln Street
Boston, MA 02111
United States

Mark Kritzman (Contact Author)

Windham Capital Management ( email )

800 Boylston Street
30th Floor
Boston, MA 02199
United States
6174193900 (Phone)
6172365034 (Fax)

Baykan Pamir

State Street Associates ( email )

140 Mt. Auburn St.
Cambridge, MA 02138
United States

David Turkington

State Street Associates ( email )

United States

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