Question

How do simulation analysis and scenario analysis differ in the way they treat very bad and very good outcomes? What does this imply about using each technique to evaluate project riskiness?

Answer 1

scenario analysis analysis possible future events by analysing alternative possible outcomes which are :

1) base case scenario 2) best case scenario 3) worst case scenario.

the base case is the expected scenario, if everything happens normally then what will be expected outcome.

very bad outcome (worst case ): for example what will happen to the prices of the bond if the interest rate increases by 10%. it analyzes the possible outcome when the worst has happened

and the very good outcome (best case) : analyzes the possible outcome, when the interest rate falls by 10%. it analysis the possible outcome when the best has happened.

by analyzing the possible scenarios an investor will be better able to decide weather to invest or not.

the simulation analysis can be used when there are a number of variables all independent to each other or all change together . the simulation process performs runs of simulations on the the various possible outcome and then takes out an average of the possible outcome.so this method is a pretty reliable one.

so in order to provide the price of the bond due to the changes in the interest rates . this method will run a number of simulations on different yield curve and its resulting bond prices and then calculate the average bond price.

the project riskiness is better evaluated by the simulation process because of the series of runs that it performs on the inputs which may be changing independently, or changing together.

the scenario analysis is very limited in its approach with only 2 scenarios best and worst. so the riskiness of a project is better measured by the simulation method as it provides a pretty accurate description of the possible scenarios.

as the number of factors increases it becomes difficult to find the base case scenario , simulation analysis is better equipped to handle multiple moving ,possibly related and uncertain factors.