Scenario Analysis, Simulation Analysis

<body onLoad="MM_checkPlugin('Shockwave Flash','','http://www.riskglossary.com/default_nofl.htm',false);return document.MM_returnValue" stylesrc="../_private/template.htm" bgcolor="#FFFFFF" link="#669933" vlink="#000000" alink="#000000"> <div align="left"> <table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" id="table1"> <tr> <td width="740"> <table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" height="37" id="table2"> <tr> <td height="35" width="100%"> <table border="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" cellpadding="0" id="table3"> <tr> <td width="100%" align="left" valign="top"> <p class="header_gold">Scenario Analysis, Simulation Analysis</td> <td width="45" align="right" valign="bottom"> <map name="FPMap6"> <area href="http://www.contingencyanalysis.com" shape="rect" coords="1, 0, 44, 11" target="_top"> </map> <img border="0" src="../images/home.gif" usemap="#FPMap6" width="45" height="12"></td> </tr> </table> </td> </tr> <tr> <td width="100%" bgcolor="#CC9966" height="2"> <img border="0" src="../images/blank_2x2.gif" width="2" height="2"></td> </tr> <tr> <td width="0%" valign="top" bgcolor="#FFFFCC"> <table border="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" cellpadding="0" cellspacing="1" id="table4"> <tr> <td width="0%" align="left" valign="top"> <p class="header2_black">Explained:<br> <img border="0" src="../images/blank_1x100.gif" width="100" height="1"></td> <td width="0%" align="left" valign="top"><p class="word_list"> <a href="#scenario analysis">scenario analysis</a><p class="word_list"> <a href="#simulation analysis">simulation analysis</a><br> <img border="0" src="../images/blank_1x160.gif" width="160" height="1"></td> <td width="100%" align="left" valign="top"><p class="word_list"> <br> <img border="0" src="../images/blank_1x160.gif" width="160" height="1"></td> </tr> </table> </td> </tr> </table> <table border="0" cellpadding="0" style="border-collapse: collapse" bordercolor="#111111" width="310" align="left" id="table5"> <tr> <td width="300" height="14"><font size="2"> </font><font size="4"> </font></td> <td width="9" height="14"></td> </tr> <tr> <td width="300"> <script type="text/javascript"></script> <script type="text/javascript" src="http://pagead2.googlesyndication.com/pagead/show_ads.js"> </script>  </td> <td width="9"> </td> </tr> </table> <p class="body">Scenario analysis is a practice that has existed as long as humans have walked this Earth. A mariner contemplates the possibility that his ship may be afflicted by storms—or pirates, or scurvy. He thinks about how he would respond to each, and what the consequences might be. He toys with different scenarios and different responses. He considers the likelihood of each scenario. Based on that, and what he perceives would be the outcome of each, he plans his next voyage.</p> <p class="body">This sort of "what if" analysis has always been a part of business decision making. Today, what we call <b> <a name="scenario analysis">scenario analysis</a></b> is a formalization of the process. Formalized scenario analysis is used in <a href="../articles/asset_liability_management.htm">asset-liability management</a> and <a href="../articles/corporate_risk_management.htm"> corporate risk management</a>. It originated in the 1970s and 1980s among banks and insurance companies when <a href="../articles/volatility.htm"> volatility</a> in interest rates emerged as a threat to their balance sheets. Its primary use remains the analysis of <a href="../articles/interest_rate_risk.htm">interest rate risk</a>, but <a href="../articles/corporation.htm">corporations</a> apply it for a variety of risks.</p> <p class="body">Scenario analysis starts with scenarios. A simple analysis might consider three scenarios, say reflecting assumptions that the economy will experience</p> <p class="bullet"><img border="0" src="../images/bullet.gif" width="20" height="10">strong growth,</p> <p class="bullet"><img border="0" src="../images/bullet.gif" width="20" height="10">moderate growth, or</p> <p class="bullet"><img border="0" src="../images/bullet.gif" width="20" height="10">a decline. </p> <p class="body">Typically, more scenarios are used to permit a variety of eventualities to be assessed. A scenario is specified as a set of "paths" that will be taken by relevant risk factors. Risk factors are typically interest rates, but they can also be exchange rates, <a href="../articles/common_stock.htm">equity</a> prices, commodity prices, <a href="../articles/volatility.htm">implied volatilities</a>—pretty much any risk factors. Scenarios all have the same horizon and time step—for example, they might specify values of interest rates at six-month intervals over the next ten years. Exhibit 1 illustrates one such scenario.</p> <div align="center"> <center> <table border="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="540" cellpadding="0" id="table6"> <tr> <td colspan="9"> <p class="exhibit_header"><span class="exhibit_header">Example Interest Rate Scenario</span><br> <span class="exhibit_subheader">Exhibit 1</span></td> </tr> <tr> <td bgcolor="#CC9966" height="2" colspan="9"> <img border="0" src="../images/blank_2x2.gif" width="2" height="2"></td> </tr> <tr> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFFF" style="border-right: 1px solid #CC9966"> <p style="margin-right: -5">time<br> (months)</td> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFFF"> <p style="margin-top: 0; margin-bottom: 0">1-month<br> Libor</td> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFFF"> <p style="margin-top: 0; margin-bottom: 0">3-month<br> Libor</td> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFFF"> <p style="margin-top: 0; margin-bottom: 0">6-month<br> Libor</td> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFFF"> <p style="margin-top: 0; margin-bottom: 0">12-month<br> Libor</td> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFFF"> <p style="margin-top: 0; margin-bottom: 0">3-year<br> Swap</td> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFFF"> <p style="margin-top: 0; margin-bottom: 0">5-year<br> Swap</td> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFFF"> <p style="margin-top: 0; margin-bottom: 0">Prime</td> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFFF"> <p style="margin-top: 0; margin-bottom: 0">COFI</td> </tr> <tr> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-left-style: solid; border-left-width: 0; border-right: 1px solid #CC9966; border-top: 1px solid #CC9966; border-bottom-style: solid; border-bottom-width: 0" bordercolor="#FFFFCC"> <p style="margin-right: -5">0</td> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-left-style: solid; border-left-width: 0; border-right-style: solid; border-right-width: 0; border-top: 1px solid #CC9966; border-bottom-style: solid; border-bottom-width: 0" bordercolor="#FFFFCC"> <p style="margin-top: 0; margin-bottom: 0">3.11</td> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-left-style: solid; border-left-width: 0; border-right-style: solid; border-right-width: 0; border-top: 1px solid #CC9966; border-bottom-style: solid; border-bottom-width: 0" bordercolor="#FFFFCC"> <p style="margin-top: 0; margin-bottom: 0">3.33</td> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-left-style: solid; border-left-width: 0; border-right-style: solid; border-right-width: 0; border-top: 1px solid #CC9966; border-bottom-style: solid; border-bottom-width: 0" bordercolor="#FFFFCC"> <p style="margin-top: 0; margin-bottom: 0">3.54</td> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-left-style: solid; border-left-width: 0; border-right-style: solid; border-right-width: 0; border-top: 1px solid #CC9966; border-bottom-style: solid; border-bottom-width: 0" bordercolor="#FFFFCC"> <p style="margin-top: 0; margin-bottom: 0">3.79</td> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-left-style: solid; border-left-width: 0; border-right-style: solid; border-right-width: 0; border-top: 1px solid #CC9966; border-bottom-style: solid; border-bottom-width: 0" bordercolor="#FFFFCC"> <p style="margin-top: 0; margin-bottom: 0">4.07</td> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-left-style: solid; border-left-width: 0; border-right-style: solid; border-right-width: 0; border-top: 1px solid #CC9966; border-bottom-style: solid; border-bottom-width: 0" bordercolor="#FFFFCC"> <p style="margin-top: 0; margin-bottom: 0">4.24</td> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-left-style: solid; border-left-width: 0; border-right-style: solid; border-right-width: 0; border-top: 1px solid #CC9966; border-bottom-style: solid; border-bottom-width: 0" bordercolor="#FFFFCC"> <p style="margin-top: 0; margin-bottom: 0">6.25</td> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-left-style: solid; border-left-width: 0; border-right-style: solid; border-right-width: 0; border-top: 1px solid #CC9966; border-bottom-style: solid; border-bottom-width: 0" bordercolor="#FFFFCC"> <p style="margin-top: 0; margin-bottom: 0">2.62</td> </tr> <tr> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-left-style: solid; border-left-width: 0; border-right: 1px solid #CC9966; border-top-style: solid; border-top-width: 0; border-bottom-style: solid; border-bottom-width: 0" bordercolor="#FFFFCC"> <p style="margin-right: -5; margin-top: 0; margin-bottom: 0">6</td> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-style: solid; border-width: 0" bordercolor="#FFFFCC"> 3.06</td> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-style: solid; border-width: 0" bordercolor="#FFFFCC"> <p style="margin-top: 0; margin-bottom: 0">3.27</td> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-style: solid; border-width: 0" bordercolor="#FFFFCC"> <p style="margin-top: 0; margin-bottom: 0">3.47</td> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-style: solid; border-width: 0" bordercolor="#FFFFCC"> <p style="margin-top: 0; margin-bottom: 0">3.71</td> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-style: solid; border-width: 0" bordercolor="#FFFFCC"> <p style="margin-top: 0; margin-bottom: 0">3.96</td> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-style: solid; border-width: 0" bordercolor="#FFFFCC"> <p style="margin-top: 0; margin-bottom: 0">4.02</td> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-style: solid; border-width: 0" bordercolor="#FFFFCC"> <p style="margin-top: 0; margin-bottom: 0">6.25</td> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-style: solid; border-width: 0" bordercolor="#FFFFCC"> <p style="margin-top: 0; margin-bottom: 0">2.68</td> </tr> <tr> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-left-style: solid; border-left-width: 0; border-right: 1px solid #CC9966; border-top-style: solid; border-top-width: 0; border-bottom-style: solid; border-bottom-width: 0" bordercolor="#FFFFCC"> <p style="margin-right: -5; margin-top: 0; margin-bottom: 0">12</td> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-style: solid; border-width: 0" bordercolor="#FFFFCC"> 3.01</td> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-style: solid; border-width: 0" bordercolor="#FFFFCC"> <p style="margin-top: 0; margin-bottom: 0">3.21</td> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-style: solid; border-width: 0" bordercolor="#FFFFCC"> <p style="margin-top: 0; margin-bottom: 0">3.40</td> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-style: solid; border-width: 0" bordercolor="#FFFFCC"> <p style="margin-top: 0; margin-bottom: 0">3.63</td> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-style: solid; border-width: 0" bordercolor="#FFFFCC"> <p style="margin-top: 0; margin-bottom: 0">3.88</td> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-style: solid; border-width: 0" bordercolor="#FFFFCC"> <p style="margin-top: 0; margin-bottom: 0">3.96</td> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-style: solid; border-width: 0" bordercolor="#FFFFCC"> <p style="margin-top: 0; margin-bottom: 0">6.25</td> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-style: solid; border-width: 0" bordercolor="#FFFFCC"> <p style="margin-top: 0; margin-bottom: 0">2.65</td> </tr> <tr> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-left-style: solid; border-left-width: 0; border-right: 1px solid #CC9966; border-top-style: solid; border-top-width: 0; border-bottom-style: solid; border-bottom-width: 0" bordercolor="#FFFFCC"> <p style="margin-right: -5; margin-top: 0; margin-bottom: 0">18</td> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-style: solid; border-width: 0" bordercolor="#FFFFCC"> 2.93</td> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-style: solid; border-width: 0" bordercolor="#FFFFCC"> <p style="margin-top: 0; margin-bottom: 0">3.15</td> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-style: solid; border-width: 0" bordercolor="#FFFFCC"> <p style="margin-top: 0; margin-bottom: 0">3.35</td> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-style: solid; border-width: 0" bordercolor="#FFFFCC"> <p style="margin-top: 0; margin-bottom: 0">3.59</td> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-style: solid; border-width: 0" bordercolor="#FFFFCC"> <p style="margin-top: 0; margin-bottom: 0">3.87</td> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-style: solid; border-width: 0" bordercolor="#FFFFCC"> <p style="margin-top: 0; margin-bottom: 0">3.96</td> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-style: solid; border-width: 0" bordercolor="#FFFFCC"> <p style="margin-top: 0; margin-bottom: 0">6.25</td> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-style: solid; border-width: 0" bordercolor="#FFFFCC"> <p style="margin-top: 0; margin-bottom: 0">2.61</td> </tr> <tr> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-left-style: solid; border-left-width: 0; border-right: 1px solid #CC9966; border-top-style: solid; border-top-width: 0; border-bottom-style: solid; border-bottom-width: 0" bordercolor="#FFFFCC"> <p style="margin-right: -5; margin-top: 0; margin-bottom: 0">24</td> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-style: solid; border-width: 0" bordercolor="#FFFFCC"> 2.95</td> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-style: solid; border-width: 0" bordercolor="#FFFFCC"> <p style="margin-top: 0; margin-bottom: 0">3.06</td> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-style: solid; border-width: 0" bordercolor="#FFFFCC"> <p style="margin-top: 0; margin-bottom: 0">3.25</td> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-style: solid; border-width: 0" bordercolor="#FFFFCC"> <p style="margin-top: 0; margin-bottom: 0">3.48</td> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-style: solid; border-width: 0" bordercolor="#FFFFCC"> <p style="margin-top: 0; margin-bottom: 0">3.74</td> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-style: solid; border-width: 0" bordercolor="#FFFFCC"> <p style="margin-top: 0; margin-bottom: 0">3.82</td> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-style: solid; border-width: 0" bordercolor="#FFFFCC"> <p style="margin-top: 0; margin-bottom: 0">6.25</td> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-style: solid; border-width: 0" bordercolor="#FFFFCC"> <p style="margin-top: 0; margin-bottom: 0">2.53</td> </tr> <tr> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-left-style: solid; border-left-width: 0; border-right: 1px solid #CC9966; border-top-style: solid; border-top-width: 0; border-bottom-style: solid; border-bottom-width: 0" bordercolor="#FFFFCC"> <p style="line-height: 50%; margin-right: -5">.<br> .<br> .<br>  </td> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-style: solid; border-width: 0" bordercolor="#FFFFCC"> <p style="line-height: 50%">.<br> .<br> .<br>  </td> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-style: solid; border-width: 0" bordercolor="#FFFFCC"> <p style="line-height: 50%">.<br> .<br> .<br>  </td> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-style: solid; border-width: 0" bordercolor="#FFFFCC"> <p style="line-height: 50%">.<br> .<br> .<br>  </td> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-style: solid; border-width: 0" bordercolor="#FFFFCC"> <p style="line-height: 50%">.<br> .<br> .<br>  </td> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-style: solid; border-width: 0" bordercolor="#FFFFCC"> <p style="line-height: 50%">.<br> .<br> .<br>  </td> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-style: solid; border-width: 0" bordercolor="#FFFFCC"> <p style="line-height: 50%">.<br> .<br> .<br>  </td> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-style: solid; border-width: 0" bordercolor="#FFFFCC"> <p style="line-height: 50%">.<br> .<br> .<br>  </td> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-style: solid; border-width: 0" bordercolor="#FFFFCC"> <p style="line-height: 50%">.<br> .<br> .<br>  </td> </tr> <tr> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-left-style: solid; border-left-width: 0; border-right: 1px solid #CC9966; border-top-style: solid; border-top-width: 0; border-bottom-style: solid; border-bottom-width: 0" bordercolor="#FFFFCC"> <p style="margin-right: -5; margin-top: 0; margin-bottom: 0">114</td> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-style: solid; border-width: 0" bordercolor="#FFFFCC"> 4.85</td> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-style: solid; border-width: 0" bordercolor="#FFFFCC"> <p style="margin-top: 0; margin-bottom: 0">4.87</td> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-style: solid; border-width: 0" bordercolor="#FFFFCC"> <p style="margin-top: 0; margin-bottom: 0">4.59</td> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-style: solid; border-width: 0" bordercolor="#FFFFCC"> <p style="margin-top: 0; margin-bottom: 0">5.02</td> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-style: solid; border-width: 0" bordercolor="#FFFFCC"> <p style="margin-top: 0; margin-bottom: 0">5.22</td> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-style: solid; border-width: 0" bordercolor="#FFFFCC"> <p style="margin-top: 0; margin-bottom: 0">5.38</td> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-style: solid; border-width: 0" bordercolor="#FFFFCC"> <p style="margin-top: 0; margin-bottom: 0">8.00</td> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-style: solid; border-width: 0" bordercolor="#FFFFCC"> <p style="margin-top: 0; margin-bottom: 0">3.98</td> </tr> <tr> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-left-style: solid; border-left-width: 0; border-right: 1px solid #CC9966; border-top-style: solid; border-top-width: 0; border-bottom-style: solid; border-bottom-width: 0" bordercolor="#FFFFCC"> <p style="margin-right: -5; margin-top: 0; margin-bottom: 0">120</td> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-style: solid; border-width: 0" bordercolor="#FFFFCC"> 4.88</td> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-style: solid; border-width: 0" bordercolor="#FFFFCC"> <p style="margin-top: 0; margin-bottom: 0">4.91</td> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-style: solid; border-width: 0" bordercolor="#FFFFCC"> <p style="margin-top: 0; margin-bottom: 0">4.64</td> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-style: solid; border-width: 0" bordercolor="#FFFFCC"> <p style="margin-top: 0; margin-bottom: 0">5.08</td> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-style: solid; border-width: 0" bordercolor="#FFFFCC"> <p style="margin-top: 0; margin-bottom: 0">5.23</td> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-style: solid; border-width: 0" bordercolor="#FFFFCC"> <p style="margin-top: 0; margin-bottom: 0">5.51</td> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-style: solid; border-width: 0" bordercolor="#FFFFCC"> <p style="margin-top: 0; margin-bottom: 0">8.00</td> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-style: solid; border-width: 0" bordercolor="#FFFFCC"> <p style="margin-top: 0; margin-bottom: 0">4.04</td> </tr> <tr> <td colspan="9" style="border-top: 2px solid #CC9966"> <p class="exhibit_legend">One hypothetical scenario that might be constructed for a bank as part of its scenario analysis. The horizon is ten years with a six-month time step.</td> </tr> </table> </center> </div> <p class="body"> Such detailed scenarios can accommodate events such as narrowing <a href="../articles/interest_rate_spreads.htm">spreads</a> or flattening of the <a href="../articles/fixed_income_term_structure.htm">yield curve</a>. Often, however, scenarios are more simplistic. Five simple scenarios might have interest rates </p> <p class="bullet" style="margin-top: 4; margin-bottom: 4"> <img border="0" src="../images/bullet.gif" width="20" height="10">rise 200 basis points, </p> <p class="bullet" style="margin-top: 4; margin-bottom: 4"> <img border="0" src="../images/bullet.gif" width="20" height="10">rise 100 basis points, </p> <p class="bullet" style="margin-top: 4; margin-bottom: 4"> <img border="0" src="../images/bullet.gif" width="20" height="10">are flat, </p> <p class="bullet" style="margin-top: 4; margin-bottom: 4"> <img border="0" src="../images/bullet.gif" width="20" height="10">decline 100 basis points, or</p> <p class="bullet" style="margin-top: 4; margin-bottom: 4"> <img border="0" src="../images/bullet.gif" width="20" height="10">decline 200 basis points. </p> <p class="body" style="margin-bottom: 24">Exhibit 2 illustrates one such scenario.</p> <div align="center"> <center> <table border="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="540" cellpadding="0" id="table7"> <tr> <td colspan="9"> <p class="exhibit_header"><span class="exhibit_header">Simple Scenario: Interest Rates Decline 100 Basis Points</span><br> <span class="exhibit_subheader">Exhibit 2</span></td> </tr> <tr> <td bgcolor="#CC9966" height="2" colspan="9"> <img border="0" src="../images/blank_2x2.gif" width="2" height="2"></td> </tr> <tr> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFFF" style="border-right: 1px solid #CC9966"> <p style="margin-right: -5">time<br> (months)</td> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFFF"> <p style="margin-top: 0; margin-bottom: 0">1-month<br> Libor</td> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFFF"> <p style="margin-top: 0; margin-bottom: 0">3-month<br> Libor</td> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFFF"> <p style="margin-top: 0; margin-bottom: 0">6-month<br> Libor</td> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFFF"> <p style="margin-top: 0; margin-bottom: 0">12-month<br> Libor</td> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFFF"> <p style="margin-top: 0; margin-bottom: 0">3-year<br> Swap</td> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFFF"> <p style="margin-top: 0; margin-bottom: 0">5-year<br> Swap</td> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFFF"> <p style="margin-top: 0; margin-bottom: 0">Prime</td> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFFF"> <p style="margin-top: 0; margin-bottom: 0">COFI</td> </tr> <tr> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-left-style: solid; border-left-width: 0; border-right: 1px solid #CC9966; border-top: 1px solid #CC9966; border-bottom-style: solid; border-bottom-width: 0" bordercolor="#FFFFCC"> <p style="margin-right: -5">0</td> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-left-style: solid; border-left-width: 0; border-right-style: solid; border-right-width: 0; border-top: 1px solid #CC9966; border-bottom-style: solid; border-bottom-width: 0" bordercolor="#FFFFCC"> <p style="margin-top: 0; margin-bottom: 0">3.11</td> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-left-style: solid; border-left-width: 0; border-right-style: solid; border-right-width: 0; border-top: 1px solid #CC9966; border-bottom-style: solid; border-bottom-width: 0" bordercolor="#FFFFCC"> <p style="margin-top: 0; margin-bottom: 0">3.33</td> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-left-style: solid; border-left-width: 0; border-right-style: solid; border-right-width: 0; border-top: 1px solid #CC9966; border-bottom-style: solid; border-bottom-width: 0" bordercolor="#FFFFCC"> <p style="margin-top: 0; margin-bottom: 0">3.54</td> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-left-style: solid; border-left-width: 0; border-right-style: solid; border-right-width: 0; border-top: 1px solid #CC9966; border-bottom-style: solid; border-bottom-width: 0" bordercolor="#FFFFCC"> <p style="margin-top: 0; margin-bottom: 0">3.79</td> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-left-style: solid; border-left-width: 0; border-right-style: solid; border-right-width: 0; border-top: 1px solid #CC9966; border-bottom-style: solid; border-bottom-width: 0" bordercolor="#FFFFCC"> <p style="margin-top: 0; margin-bottom: 0">4.07</td> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-left-style: solid; border-left-width: 0; border-right-style: solid; border-right-width: 0; border-top: 1px solid #CC9966; border-bottom-style: solid; border-bottom-width: 0" bordercolor="#FFFFCC"> <p style="margin-top: 0; margin-bottom: 0">4.24</td> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-left-style: solid; border-left-width: 0; border-right-style: solid; border-right-width: 0; border-top: 1px solid #CC9966; border-bottom-style: solid; border-bottom-width: 0" bordercolor="#FFFFCC"> <p style="margin-top: 0; margin-bottom: 0">6.25</td> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-left-style: solid; border-left-width: 0; border-right-style: solid; border-right-width: 0; border-top: 1px solid #CC9966; border-bottom-style: solid; border-bottom-width: 0" bordercolor="#FFFFCC"> <p style="margin-top: 0; margin-bottom: 0">2.62</td> </tr> <tr> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-left-style: solid; border-left-width: 0; border-right: 1px solid #CC9966; border-top-style: solid; border-top-width: 0; border-bottom-style: solid; border-bottom-width: 0" bordercolor="#FFFFCC"> <p style="margin-right: -5; margin-top: 0; margin-bottom: 0">6</td> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-style: solid; border-width: 0" bordercolor="#FFFFCC"> 2.11</td> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-style: solid; border-width: 0" bordercolor="#FFFFCC"> 2.33</td> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-style: solid; border-width: 0" bordercolor="#FFFFCC"> 2.54</td> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-style: solid; border-width: 0" bordercolor="#FFFFCC"> 2.79</td> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-style: solid; border-width: 0" bordercolor="#FFFFCC"> 3.07</td> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-style: solid; border-width: 0" bordercolor="#FFFFCC"> 3.24</td> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-style: solid; border-width: 0" bordercolor="#FFFFCC"> 5.25</td> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-style: solid; border-width: 0" bordercolor="#FFFFCC"> 2.62</td> </tr> <tr> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-left-style: solid; border-left-width: 0; border-right: 1px solid #CC9966; border-top-style: solid; border-top-width: 0; border-bottom-style: solid; border-bottom-width: 0" bordercolor="#FFFFCC"> <p style="margin-right: -5; margin-top: 0; margin-bottom: 0">12</td> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-style: solid; border-width: 0" bordercolor="#FFFFCC"> 2.11</td> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-style: solid; border-width: 0" bordercolor="#FFFFCC"> 2.33</td> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-style: solid; border-width: 0" bordercolor="#FFFFCC"> 2.54</td> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-style: solid; border-width: 0" bordercolor="#FFFFCC"> 2.79</td> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-style: solid; border-width: 0" bordercolor="#FFFFCC"> 3.07</td> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-style: solid; border-width: 0" bordercolor="#FFFFCC"> 3.24</td> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-style: solid; border-width: 0" bordercolor="#FFFFCC"> 5.25</td> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-style: solid; border-width: 0" bordercolor="#FFFFCC"> 1.62</td> </tr> <tr> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-left-style: solid; border-left-width: 0; border-right: 1px solid #CC9966; border-top-style: solid; border-top-width: 0; border-bottom-style: solid; border-bottom-width: 0" bordercolor="#FFFFCC"> <p style="margin-right: -5; margin-top: 0; margin-bottom: 0">18</td> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-style: solid; border-width: 0" bordercolor="#FFFFCC"> 2.11</td> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-style: solid; border-width: 0" bordercolor="#FFFFCC"> 2.33</td> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-style: solid; border-width: 0" bordercolor="#FFFFCC"> 2.54</td> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-style: solid; border-width: 0" bordercolor="#FFFFCC"> 2.79</td> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-style: solid; border-width: 0" bordercolor="#FFFFCC"> 3.07</td> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-style: solid; border-width: 0" bordercolor="#FFFFCC"> 3.24</td> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-style: solid; border-width: 0" bordercolor="#FFFFCC"> 5.25</td> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-style: solid; border-width: 0" bordercolor="#FFFFCC"> 1.62</td> </tr> <tr> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-left-style: solid; border-left-width: 0; border-right: 1px solid #CC9966; border-top-style: solid; border-top-width: 0; border-bottom-style: solid; border-bottom-width: 0" bordercolor="#FFFFCC"> <p style="margin-right: -5; margin-top: 0; margin-bottom: 0">24</td> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-style: solid; border-width: 0" bordercolor="#FFFFCC"> 2.11</td> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-style: solid; border-width: 0" bordercolor="#FFFFCC"> 2.33</td> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-style: solid; border-width: 0" bordercolor="#FFFFCC"> 2.54</td> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-style: solid; border-width: 0" bordercolor="#FFFFCC"> 2.79</td> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-style: solid; border-width: 0" bordercolor="#FFFFCC"> 3.07</td> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-style: solid; border-width: 0" bordercolor="#FFFFCC"> 3.24</td> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-style: solid; border-width: 0" bordercolor="#FFFFCC"> 5.25</td> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-style: solid; border-width: 0" bordercolor="#FFFFCC"> 1.62</td> </tr> <tr> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-left-style: solid; border-left-width: 0; border-right: 1px solid #CC9966; border-top-style: solid; border-top-width: 0; border-bottom-style: solid; border-bottom-width: 0" bordercolor="#FFFFCC"> <p style="line-height: 50%; margin-right: -5">.<br> .<br> .<br>  </td> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-style: solid; border-width: 0" bordercolor="#FFFFCC"> <p style="line-height: 50%">.<br> .<br> .<br>  </td> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-style: solid; border-width: 0" bordercolor="#FFFFCC"> <p style="line-height: 50%">.<br> .<br> .<br>  </td> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-style: solid; border-width: 0" bordercolor="#FFFFCC"> <p style="line-height: 50%">.<br> .<br> .<br>  </td> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-style: solid; border-width: 0" bordercolor="#FFFFCC"> <p style="line-height: 50%">.<br> .<br> .<br>  </td> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-style: solid; border-width: 0" bordercolor="#FFFFCC"> <p style="line-height: 50%">.<br> .<br> .<br>  </td> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-style: solid; border-width: 0" bordercolor="#FFFFCC"> <p style="line-height: 50%">.<br> .<br> .<br>  </td> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-style: solid; border-width: 0" bordercolor="#FFFFCC"> <p style="line-height: 50%">.<br> .<br> .<br>  </td> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-style: solid; border-width: 0" bordercolor="#FFFFCC"> <p style="line-height: 50%">.<br> .<br> .<br>  </td> </tr> <tr> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-left-style: solid; border-left-width: 0; border-right: 1px solid #CC9966; border-top-style: solid; border-top-width: 0; border-bottom-style: solid; border-bottom-width: 0" bordercolor="#FFFFCC"> <p style="margin-right: -5; margin-top: 0; margin-bottom: 0">114</td> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-style: solid; border-width: 0" bordercolor="#FFFFCC"> 2.11</td> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-style: solid; border-width: 0" bordercolor="#FFFFCC"> 2.33</td> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-style: solid; border-width: 0" bordercolor="#FFFFCC"> 2.54</td> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-style: solid; border-width: 0" bordercolor="#FFFFCC"> 2.79</td> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-style: solid; border-width: 0" bordercolor="#FFFFCC"> 3.07</td> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-style: solid; border-width: 0" bordercolor="#FFFFCC"> 3.24</td> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-style: solid; border-width: 0" bordercolor="#FFFFCC"> 5.25</td> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-style: solid; border-width: 0" bordercolor="#FFFFCC"> 1.62</td> </tr> <tr> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-left-style: solid; border-left-width: 0; border-right: 1px solid #CC9966; border-top-style: solid; border-top-width: 0; border-bottom-style: solid; border-bottom-width: 0" bordercolor="#FFFFCC"> <p style="margin-right: -5; margin-top: 0; margin-bottom: 0">120</td> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-style: solid; border-width: 0" bordercolor="#FFFFCC"> 2.11</td> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-style: solid; border-width: 0" bordercolor="#FFFFCC"> 2.33</td> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-style: solid; border-width: 0" bordercolor="#FFFFCC"> 2.54</td> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-style: solid; border-width: 0" bordercolor="#FFFFCC"> 2.79</td> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-style: solid; border-width: 0" bordercolor="#FFFFCC"> 3.07</td> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-style: solid; border-width: 0" bordercolor="#FFFFCC"> 3.24</td> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-style: solid; border-width: 0" bordercolor="#FFFFCC"> 5.25</td> <td width="60" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-style: solid; border-width: 0" bordercolor="#FFFFCC"> 1.62</td> </tr> <tr> <td colspan="9" style="border-top: 2px solid #CC9966"> <p class="exhibit_legend">Scenarios can be quite simple, say assuming that interest rates immediately decline by 100 basis points and stay at that level for the duration of the scenario. Note that, in this scenario, a six-month lag is assumed for the response of <a href="../articles/cofi_index.htm">COFI</a> to the sudden decline in rates.</td> </tr> </table> </center> </div> <table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="345" align="right" id="table8"> <tr> <td align="right" width="9" height="10"></td> <td width="336" height="10"> <font size="2"> </font></td> </tr> <tr> <td align="right" width="9"> </td> <td width="336"> <script type="text/javascript"></script> <script type="text/javascript" src="http://pagead2.googlesyndication.com/pagead/show_ads.js"> </script>  </td> </tr> </table> <p class="body">Once scenarios have been specified, the next step is to project what will happen under each one. If a bank is performing the analysis, this might entail projecting what effect evolving interest rates will have on the level of demand deposits, commercial loans and residential mortgage loans. Performed at each time step, this will generate paths for the evolution of each. The analysis might project for one scenario, say, declining demand deposits over time, rising and then declining commercial loans, etc. Management actions may also be projected under each scenario. Under one scenario, they might be projected to increase borrowing in the Eurodollar market and later reallocating resources from one business line to another. An elaborate analysis might project, under each scenario, a bank's cash-flow statement and balance sheet at each time step.</p> <p class="body">Output can take many forms. It may focus on <a href="../articles/corporate_risk_management.htm">economic value</a>, but it is more common to focus on earnings, cash flow or other accounting results. Exhibit 3 illustrates typical output, detailing the evolution of net interest income over time for each of several scenarios.</p> <div align="center"> <center> <table border="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="450" cellpadding="0" id="table9"> <tr> <td colspan="6"> <p class="exhibit_header"><span class="exhibit_header">Example Output: Net Interest Income by Scenario</span><br> <span class="exhibit_subheader">Exhibit 3</span></td> </tr> <tr> <td bgcolor="#CC9966" height="2" colspan="6"> <img border="0" src="../images/blank_2x2.gif" width="2" height="2"></td> </tr> <tr> <td width="75" class="exhibit_legend" align="center" bgcolor="#FFFFFF" style="border-right: 1px solid #CC9966"> <p style="margin-bottom: -7"> </td> <td width="375" class="exhibit_legend" align="center" bgcolor="#FFFFFF" colspan="5"> <p style="margin-top: 6; margin-bottom: 6"><b>Interest Rate Scenario</b></td> </tr> <tr> <td width="75" class="exhibit_legend" align="center" bgcolor="#FFFFFF" style="border-right: 1px solid #CC9966"> <p style="margin-right: -5; margin-bottom: -7">time<br> (months)</td> <td width="75" class="exhibit_legend" align="center" bgcolor="#FFFFFF"> <p style="margin-top: 0; margin-bottom: 0">decline<br> 200 bp</td> <td width="75" class="exhibit_legend" align="center" bgcolor="#FFFFFF"> <p style="margin-top: 0; margin-bottom: 0">decline<br> 100 bp</td> <td width="75" class="exhibit_legend" align="center" bgcolor="#FFFFFF"> <p style="margin-top: 0; margin-bottom: 0">flat</td> <td width="75" class="exhibit_legend" align="center" bgcolor="#FFFFFF"> <p style="margin-top: 0; margin-bottom: 0">rise<br> 100 bp</td> <td width="75" class="exhibit_legend" align="center" bgcolor="#FFFFFF"> <p style="margin-top: 0; margin-bottom: 0">rise<br> 200 bp</td> </tr> <tr> <td width="75" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-left-style: solid; border-left-width: 0; border-right: 1px solid #CC9966; border-top: 1px solid #CC9966; border-bottom-style: solid; border-bottom-width: 0" bordercolor="#FFFFCC"> <p style="margin-right: -5; margin-bottom: -7">0</td> <td width="75" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-left-style: solid; border-left-width: 0; border-right-style: solid; border-right-width: 0; border-top: 1px solid #CC9966; border-bottom-style: solid; border-bottom-width: 0" bordercolor="#FFFFCC"> 27</td> <td width="75" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-left-style: solid; border-left-width: 0; border-right-style: solid; border-right-width: 0; border-top: 1px solid #CC9966; border-bottom-style: solid; border-bottom-width: 0" bordercolor="#FFFFCC"> 27</td> <td width="75" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-left-style: solid; border-left-width: 0; border-right-style: solid; border-right-width: 0; border-top: 1px solid #CC9966; border-bottom-style: solid; border-bottom-width: 0" bordercolor="#FFFFCC"> 27</td> <td width="75" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-left-style: solid; border-left-width: 0; border-right-style: solid; border-right-width: 0; border-top: 1px solid #CC9966; border-bottom-style: solid; border-bottom-width: 0" bordercolor="#FFFFCC"> 27</td> <td width="75" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-left-style: solid; border-left-width: 0; border-right-style: solid; border-right-width: 0; border-top: 1px solid #CC9966; border-bottom-style: solid; border-bottom-width: 0" bordercolor="#FFFFCC"> 27</td> </tr> <tr> <td width="75" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-left-style: solid; border-left-width: 0; border-right: 1px solid #CC9966; border-top-style: solid; border-top-width: 0; border-bottom-style: solid; border-bottom-width: 0" bordercolor="#FFFFCC"> <p style="margin-right: -5; margin-top: 0; margin-bottom: -7">6</td> <td width="75" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-left-style: solid; border-left-width: 0; border-right-style: solid; border-right-width: 0; border-top-style: solid; border-top-width: 1; border-bottom-style: solid; border-bottom-width: 0" bordercolor="#FFFFCC"> <p style="margin-top: 0; margin-bottom: 0">38</td> <td width="75" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-left-style: solid; border-left-width: 0; border-right-style: solid; border-right-width: 0; border-top-style: solid; border-top-width: 1; border-bottom-style: solid; border-bottom-width: 0" bordercolor="#FFFFCC"> 32</td> <td width="75" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-left-style: solid; border-left-width: 0; border-right-style: solid; border-right-width: 0; border-top-style: solid; border-top-width: 1; border-bottom-style: solid; border-bottom-width: 0" bordercolor="#FFFFCC"> 27</td> <td width="75" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-left-style: solid; border-left-width: 0; border-right-style: solid; border-right-width: 0; border-top-style: solid; border-top-width: 1; 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margin-bottom: -7">114</td> <td width="75" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-style: solid; border-width: 0" bordercolor="#FFFFCC"> 36</td> <td width="75" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-style: solid; border-width: 0" bordercolor="#FFFFCC"> 37</td> <td width="75" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-style: solid; border-width: 0" bordercolor="#FFFFCC"> 38</td> <td width="75" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-style: solid; border-width: 0" bordercolor="#FFFFCC"> 40</td> <td width="75" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-style: solid; border-width: 0" bordercolor="#FFFFCC"> 43</td> </tr> <tr> <td width="75" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-left-style: solid; border-left-width: 0; border-right: 1px solid #CC9966; border-top-style: solid; border-top-width: 0; border-bottom-style: solid; border-bottom-width: 0" bordercolor="#FFFFCC"> <p style="margin-right: -5; margin-top: 0; margin-bottom: -7">120</td> <td width="75" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-style: solid; border-width: 0" bordercolor="#FFFFCC"> 36</td> <td width="75" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-style: solid; border-width: 0" bordercolor="#FFFFCC"> 37</td> <td width="75" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-style: solid; border-width: 0" bordercolor="#FFFFCC"> 38</td> <td width="75" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-style: solid; border-width: 0" bordercolor="#FFFFCC"> 40</td> <td width="75" class="exhibit_legend" align="center" bgcolor="#FFFFCC" style="border-style: solid; border-width: 0" bordercolor="#FFFFCC"> 43</td> </tr> <tr> <td colspan="6" style="border-top: 2px solid #CC9966"> <p class="exhibit_legend">Sample output of scenario analysis for a bank. Five scenarios are considered. Each assumes a specific basis point change in interest rates, which then remains unchanged for the duration of the scenario. Projected net interest income (in millions of <a href="../articles/currency_codes.htm">USD</a>) is presented over time under each.</td> </tr> </table> </center> </div> <p class="body">Scenario analysis is an important tool of asset-liability management. Unlike other tools, such as <a href="../articles/gap_analysis.htm">gap analysis</a> or <a href="../articles/duration_and_convexity.htm">duration</a>, it is very flexible. Gap analysis cannot address <a href="../articles/option.htm"> options</a> risk or anticipate the evolution of future business or management decisions. Scenario analysis can. Duration can, if implemented correctly, address options risk, but it only addresses interest rate risk due to parallel shifts in the <a href="../articles/fixed_income_term_structure.htm">spot curve</a>. Scenario analysis, by comparison, can consider all sorts of movements in the spot curve—flattening, steepening, becoming inverted, etc. Gap analysis and duration cannot address <a href="../articles/spread_risk.htm">basis risk</a>. Scenario analysis can.</p> <table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="165" align="left" id="table10"> <tr> <td width="160"> <script type="text/javascript"></script> <script type="text/javascript" src="http://pagead2.googlesyndication.com/pagead/show_ads.js"> </script> </td> <td width="11"> </td> </tr> </table> <p class="body">Scenario analysis has several shortcomings. It only addresses risk due to the specific scenarios considered. Furthermore, there is always a risk that scenarios don't consider a long enough horizon. US thrifts learned this lesson the hard way in the 1980s, when they performed short-term scenario analysis on the <a href="../articles/mortgage_backed_security.htm">mortgage-backed securities</a> (MBSs) they were over-paying for. The analyses captured the attractive short-term earnings from the MBSs, but the horizon didn't extend long enough to predict the crushing effect of the subsequent <a href="../articles/prepayment.htm">prepayments</a>. Many of the thrifts failed.</p> <p class="body">Scenario analysis is highly dependent on assumptions. Assumptions must be made about, say, the impact of a flattening term structure on a bank's business lines or the response of management to a decline in demand deposits. Output of the analysis is only as good as these assumptions. The more elaborate the scenario analysis, the more assumptions that must be made.</p> <p class="body">Finally, output of scenario analysis tends to be cumbersome—multiple tables summarizing results as opposed to, say, the single number that is duration. </p> <p class="body">In its early days, scenario analysis was largely a manual process—performed with pencil and paper, and maybe an electronic calculator. This limited the number of scenarios that could be considered. Gathering balance sheet information and other inputs from various departments was a time consuming task. Only simple analyses were performed.</p> <p class="body">Advances in computer technology have changed this. Networked computers and centralized databases makes it easy to gather inputs. Large numbers of scenarios can be considered, and analyses of those scenarios can be elaborate.</p> <p class="body"> Sometimes, scenario analysis is performed as a <a href="../articles/monte_carlo_method.htm">Monte Carlo</a> simulation. A large number of scenarios is randomly generated, and results are calculated under each based upon formulaic assumptions regarding how business will evolve in given circumstances. Output, rather than being presented on a scenario-by-scenario basis, is presented in terms of frequency distributions. Treating these as probability distributions, summary statistics—such as <a href="../articles/corporate_risk_management.htm">earnings-at-risk</a>—are calculated. </p> <p class="body">Often, you will hear the terms "scenario analysis" and "simulation analysis" used interchangeably. If there is a distinction between them, it is that some practitioners reserve <b> <a name="simulation analysis">simulation analysis</a></b> to refer to the above form of Monte Carlo analysis. That is how I use the term in this glossary.</p> <table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" id="table11"> <tr> <td height="30" valign="bottom" colspan="2"> <p class="header2_black">Related Internal Links</td> </tr> <tr> <td colspan="2" bgcolor="#CC9966" height="2"> <img border="0" src="../images/blank_2x2.gif" width="2" height="2"></td> </tr> <tr> <td bgcolor="#FFFFCC" colspan="2"> <table border="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" cellpadding="6" id="table12"> <tr> <td width="100%"> <p class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><span class="verdana10"><strong style="font-weight: 400"><a href="../articles/asset_liability_management.htm">asset-liability management</a></strong></span><strong style="font-weight: 400"> Techniques for protecting a firm's solvency in the context of accrual accounting.</strong><p class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><a href="../articles/corporate_risk_management.htm">corporate risk management</a> Practices that serve to optimize risk taking in a context of book value accounting.<p class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><a href="../articles/duration_and_convexity.htm">duration and convexity</a> Factor sensitivities often used in asset-liability management.<p class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><a href="../articles/risk_management.htm">financial risk management</a> Practices by which a firm optimizes the manner in which it takes financial risk.<p class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><strong style="font-weight: 400"><a href="../articles/gap_analysis.htm">gap analysis</a> A technique of asset-liability management used to assess interest rate risk or liquidity risk.</strong></p> <p class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><a href="../articles/interest_rate_risk.htm">interest rate risk</a> Risk due to uncertain future interest rates.</p> <p class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><a href="../articles/interest_rate_spreads.htm">interest rate spreads</a> <i>An overview.</i></p> <p class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><a href="../articles/liquidity.htm">liquidity</a> Used in various senses, all relating to availability of, access to, or convertibility into cash.</p> <p class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><strong style="font-weight: 400"><a href="../articles/model_risk.htm">model risk</a> T</strong>he risk that models are applied to tasks for which they are inappropriate or are otherwise implemented incorrectly.</p> <p class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><strong style="font-weight: 400"><a href="../articles/monte_carlo_method.htm">Monte Carlo method</a> The use of statistical sampling to solve quantitative problems.</strong></p> <p align="left" class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><strong style="font-weight: 400"><a href="../articles/option_adjusted_spread.htm">option-adjusted spread</a> Yield spread not attributable to embedded options.</strong></p> <p align="left" class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><a href="../articles/reinvestment_risk.htm">reinvestment risk</a> Risk from uncertainty in the interest rate at which future cash flows may be invested.</p> <p class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><strong style="font-weight: 400"><a href="../articles/stress_testing.htm">stress testing</a> A simple form of scenario analysis typically used to assess market risk.</strong><p class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><a href="../articles/valuation.htm">valuation</a> <i>Article about book value and market value accounting.</i></td> </tr> </table> </td> </tr> <tr> <td height="30" valign="bottom" colspan="2"> <p class="header2_black">Sponsored Links</td> </tr> <tr> <td colspan="2" bgcolor="#CC9966" height="2"> <img border="0" src="../images/blank_2x2.gif" width="2" height="2"></td> </tr> <tr> <td bgcolor="#FFFFCC" width="75"> <img border="0" src="../images/ad_side_banner_3.jpg" width="103" height="285"></td> <td bgcolor="#FFFFCC" width="99%">  <p class="ad_legend" style="margin-left: 0; 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Uyemura and D. Van Deventer</b></td> </tr> <tr> <td width="10%"> <map name="FPMap474"> <area target="_blank" href="http://www.riskbook.com/main/ratings.htm" shape="rect" coords="0, 0, 89, 15"> </map> <img border="0" src="../images/star_5.gif" usemap="#FPMap474" width="90" height="16"></td> <td width="10%" class="author">quality</td> <td width="70%"> <p class="author"> </td> </tr> <tr> <td width="10%"> <map name="FPMap427"> <area target="_blank" href="http://www.riskbook.com/main/ratings.htm" shape="rect" coords="0, 0, 89, 15"> </map><img border="0" src="../images/tech_2.gif" usemap="#FPMap427" width="90" height="16"></td> <td width="10%" class="author">technical</td> <td width="70%">  </td> </tr> <tr> <td width="10%"> <p class="author">1993</td> <td width="10%"> </td> <td width="70%"> <p align="center"><map name="FPMap366"> <area target="_blank" coords="0, 0, 145, 19" shape="rect" href="http://www.riskbook.com/link/uyemura_and_van_deveneter.htm"> </map> <img border="0" src="../images/pointer_review.gif" usemap="#FPMap366" width="146" height="20"></td> </tr> </table> </td> </tr> </table> <table border="0" cellpadding="4" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" id="table15"> <tr> <td width="100" align="left" valign="top"> <map name="FPMap534"> <area target="_blank" href="http://www.riskbook.com/link/van_deventer_imai_mesler_(2004).htm" shape="rect" coords="0, 0, 83, 124"> </map> <img border="0" src="../images/book_van_deventer_imai_mesler_(2004)_125.gif" usemap="#FPMap534" width="84" height="125"></td> <td align="left" valign="top"> <table border="0" cellpadding="1" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" id="table16"> <tr> <td width="90%" colspan="3"> <p class="title"> <a target="_blank" href="http://www.riskbook.com/link/van_deventer_imai_mesler_(2004).htm"> Advanced Financial Risk Management</a> </td> </tr> <tr> <td colspan="3"> <p class="author"><b>D. van Deventer, K. Imai and M. Mesler</b></td> </tr> <tr> <td width="10%"> <map name="FPMap362"> <area target="_blank" href="http://www.riskbook.com/main/ratings.htm" shape="rect" coords="0, 0, 89, 15"></map> <img border="0" src="../images/star_6.gif" usemap="#FPMap362" width="90" height="16"></td> <td width="10%" class="author">quality</td> <td width="70%"> <p class="author"> </td> </tr> <tr> <td width="10%"> <span style="font-family: Times New Roman; letter-spacing: -0.2pt"> <map name="FPMap533"> <area target="_blank" href="http://www.riskbook.com/main/ratings.htm" shape="rect" coords="1, 2, 89, 15"> </map> <img border="0" src="../images/tech_3.gif" usemap="#FPMap533" width="90" height="16"></span></td> <td width="10%" class="author">technical</td> <td width="70%">  </td> </tr> <tr> <td width="10%"> <p class="author">2004</td> <td width="10%"> </td> <td width="70%"> <p align="center"><map name="FPMap37"> <area target="_blank" coords="0, 0, 145, 19" shape="rect" href="http://www.riskbook.com/link/van_deventer_imai_mesler_(2004).htm"> </map> <img border="0" src="../images/pointer_review.gif" usemap="#FPMap37" width="146" height="20"></td> </tr> </table> </td> </tr> </table> </td> </tr> <tr> <td bgcolor="#FFFFCC" colspan="2"> <table border="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" cellpadding="6" id="table17"> <tr> <td width="100%" bgcolor="#FFFFFF"> <p align="center" style="margin-top: 18"><map name="FPMap365"> <area target="_top" href="http://www.riskglossary.com" shape="rect" coords="0, 0, 164, 102"> </map><img border="0" src="../images/logo.jpg" usemap="#FPMap365" width="165" height="103"></p> <p align="center"><span class="verdana10"> <a href="http://www.riskglossary.com/main/disclaimer.htm" target="_self"> Disclaimer</a></span></p> <p align="center">website: <span class="verdana10"> <a target="_top" href="http://www.contingencyanalysis.com"> http://www.contingencyanalysis.com</a></span><br> glossary direct link: <span class="verdana10"> <a target="_top" href="http://www.riskglossary.com"> http://www.riskglossary.com</a></span><br> copyright © Contingency Analysis, 2005<p align="center"><map name="FPMap1"> <area target="_top" href="http://www.contingencyanalysis.com" shape="rect" coords="0, 0, 240, 88"> </map><img border="0" src="../images/logo_glossary_white.gif" usemap="#FPMap1" width="241" height="89"></td> </tr> </table> </td> </tr> </table> </td> <td>  </td> </tr> </table> </div> </body>