What characterizes scenario analysis in risk management?

Scenario analysis in risk management is characterized by its focus on considering large movements in key variables affecting values. This method is essential for understanding the potential impact of extreme market conditions or significant changes in economic factors, as it allows for the assessment of risks that might not be captured by standard models that predominantly rely on historical data or minor variations.

By analyzing scenarios with substantial shifts in variables, decision-makers can better prepare for adverse outcomes and develop more robust strategies to mitigate risks. This approach is particularly valuable in volatile environments, where small changes may not adequately reflect possible real-world consequences.

In contrast, relying solely on historical data limits the analysis to past performance, which may not be indicative of future events, especially in rapidly changing markets. Focusing on minor changes does not capture the potential for significant risks, and examining only average case scenarios can obscure the understanding of possible extremes that could have severe implications. Therefore, the correct characterization of scenario analysis is its emphasis on large movements in key variables.