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Scenario Analysis

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PROBABILISTIC APPROACHES: SCENARIO ANALYSIS, DECISION TREES AND SIMULATIONS
In the last chapter, we examined ways in which we can adjust the value of a risky asset for its risk. Notwithstanding their popularity, all of the approaches share a common theme. The riskiness of an asset is encapsulated in one number – a higher discount rate, lower cash flows or a discount to the value – and the computation almost always requires us to make assumptions (often unrealistic) about the nature of risk. In this chapter, we consider a different and potentially more informative way of assessing and presenting the risk in an investment. Rather than compute an expected value for an asset that that tries to reflect the different possible outcomes, we could provide information on what the value of the asset will be under each outcome or at least a subset of outcomes. We will begin this section by looking at the simplest version which is an analysis of an asset’s value under three scenarios – a best case, most likely case and worse case – and then extend the discussion to look at scenario analysis more generally. We will move on to examine the use of decision trees, a more complete approach to dealing with discrete risk. We will close the chapter by evaluating Monte Carlo simulations, the most complete approach of assessing risk across the spectrum.

Scenario Analysis The expected cash flows that we use to value risky assets can be estimated in one or two ways. They can represent a probability-weighted average of cash flows under all possible scenarios or they can be the cash flows under the most likely scenario. While the former is the more precise measure, it is seldom used simply because it requires far more information to compile. In both cases, there are other scenarios where the cash flows will be different from expectations; higher than expected in some and lower than

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is
a
group‐based
decision
making
tool, which
has
its
roots
in
post‐
WWII
military
planning
and
the
petroleum
industry
of
the
1970s such as Royal Dutch Company.
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cousins, 
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outcomes
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 the
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vision”, 
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 one
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 as
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 by
 Peter
 Schwartz, 
 Chairman
 of
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a
tool
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and
governments
employ
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tool
because
it
helps
them
to
make
better
strategic
decisions.”

 (Schlegel, G. L., & Murray, P. 2010) The History
of
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 a
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 filled
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 much
uncertainty.
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particularly
magnified
in
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operations,
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 planning
 can
 be
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 back
 to
 19‐century
 military
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