Scenario Analysis
Scenario analysis is testing how a portfolio or investment might perform under specific market or business conditions (e.g., recession, rate spike, credit stress).
Allocator relevance: A core risk tool—helps quantify downside, liquidity needs, and concentration effects before stress hits.
Expanded Definition
Scenario analysis goes beyond point estimates like volatility. It asks “what if” and forces explicit assumptions: what happens to NAV marks, credit spreads, capital calls, distributions, and correlation in a stress regime. For illiquid portfolios, scenario analysis often uses proxies and conservative assumptions, but it still provides decision clarity.
Allocators use scenarios to set risk budgets, liquidity sleeves, and pacing decisions.
How It Works in Practice
Teams define scenarios (macro, sector, idiosyncratic), apply shocks to exposures, and estimate portfolio-level impacts. They also incorporate second-order effects: distribution slowdown, higher default risk, and gating/redemption queues.
Decision Authority and Governance
Governance defines required scenarios, modeling cadence, and escalation triggers when downside exceeds risk limits. Good governance treats scenarios as decision inputs, not slideware.
Common Misconceptions
- Scenario analysis predicts the future.
- It’s only for public markets.
- One macro scenario is enough.
Key Takeaways
- Scenarios clarify fragility and liquidity needs.
- Stress regimes change correlations and liquidity.
- Use scenarios to enforce sizing discipline.