Scenario and Sensitivity Analysis

Announcer 1  0:07   

Welcome to the Treasury Update Podcast presented by Strategic Treasurer, your source for interesting treasury news, analysis, and insights in your car, at the gym, or wherever you decide to tune in. 

Craig Jeffery  0:23   

Welcome to the Treasury Update Podcast. This is Craig Jeffrey, your host today on this edition. We are talking about scenario and sensitivity analysis. I’m joined with my colleague Paul Galloway. Paul, welcome to the Treasure Update Podcast. 

Paul Galloway  0:38   

Thanks, Craig. 

Craig Jeffery  0:40   

I want to ask you a number of questions in and around scenario and sensitivity analysis. Maybe we can begin this discussion of scenario sensitivity analysis.  Why this maybe more of a concern than normal, given changing interest rates, volatility among FX currency pairs. We won’t even talk about commodity price swings and inflation. You know, maybe as part of your answer to the questions – What is scenario and sensitivity analysis? – maybe you could roll some of that in as we move forward in our discussion. 

Paul Galloway  1:16   

Yes, sure. Craig, definitely scenario and sensitivity analysis has become much more important in today’s environment. We currently have rising interest rates, we have inflation, we have geopolitical issues going on, not to mention COVID impacts, supply chain disruptions. All these different things that are happening have an impact on outcomes of either projects that we’re working on or decision points for raising capital or mergers and acquisitions or leasing or investing in products, all kinds of different things. When we think about scenario and sensitivity analysis, go first with what is scenario analysis?  Scenario analysis is simply saying I took the base case analysis I put together for anyone or any number of projects or things that I’m looking to make decisions on. I change one or more variables I could add or subtract a variable data that I have in the base case, but you’re changing multiple variables at the same time. We’re moving and adding variables. And what this does is for the various events I talked about, allows you to take a look at impacts to generally it’s normally in financial impacts to what it is that you’re running the analysis on. And so you’re trying to figure out, you know, does this change the outcome to a point that I would make a different decision than what my base case says? Sensitivity analysis is different in that it looks at a single variable and you pressure test the variable.  You can do new extremes.  Maybe it’s bandwidth, if interest rates increased by X percent, or dropped by X percent, what’s the outcome of changing that variable of about? And so that’s the difference between scenario analysis and sensitivity analysis. Obviously, in today’s environment, there’s so many things that are have an impact on decision making today. These two approaches to looking at variables title and analysis are more more important. 

Craig Jeffery  3:25   

Maybe to see if I’ve captured the way you describe that correctly. The sensitivity analysis you’re really obviously have a number of variables sensitivity analysis, as you’re isolating one of those, I think you used the term pressure test. You’re jumping inflation or interest rates go up or down, you know, a certain amount of pressure stress or stress the current the outcome of that will show you what that does to your portfolio with it those to income or cash flow or some other outcome. Is that an accurate reflection of that or would you add to that when it comes to pressure testing those variables? 

Paul Galloway  3:50   

I think the way you say it is correct, it’s fair. That’s exactly what you’re wanting to do with sensitivity analysis. 

Craig Jeffery  3:56   

So what are some of the variables that treasurers are focused on with regard to either scenarios or sensitivity where we talked about FX interest rates inflation? Are there other key variables that people are usually testing? 

Paul Galloway  4:06   

You know, obviously, interest rates and FX are two things that treasurers are focused on. They’re focused on these things for a variety of reasons, but when you think about interest income or interest payments, or when it comes to paying for something in a foreign currency versus your U.S. dollar or local currency as we term it here, you as a treasurer, yearning to be monitoring these various things. And treasurers often have to make decisions around capital management or capital funding. Some of the components tied to that or interest rates in general. What’s going on out in the markets? And so as the Fed raises interest rates or or rates are rising in markets the underlying benchmark rate that’s used to determine cost of financing will change, and so if it’s fixed, typically it’s Treasury’s that we’re looking at, if it’s floating, it used to be that Libor was typically used, but now that Libor is going away, you’re seeing issuances come out and using SOFR, which is a US based floating rate benchmark that a lot of treasures are using today when it comes to capital financing with floating rate instruments. So, when you’re engaging in capital management or raising of capital, you’re going to monitor the markets and see what the impact is to debt or financing for your cash flows and your costs. The other thing you’re going to be monitoring as a treasurer is what’s going on with foreign exchange, so in particular we’re seeing right now that the dollar has been strengthening quite significantly against the euro today. The euro most recently reached parity with the US dollar and that hasn’t happened in a long time. So when you’re having to pay for things and local currencies that are non-us dollar local currencies, say euros for instance, you’re interested in what’s going on with those rates. So you will run scenarios or sensitivity analysis to determine what the impacts might be to the financials, to your costs, to your capital raising, and also determine, you know ,what does that mean from a risk management standpoint and so risk management comes into play. Do I want to engage in certain activities that will help me manage the risk of either rates, interest rates, or foreign currencies moving on me in a direction that might be adverse. 

00:07:31 Craig Jeffery 

OK, so I think that helps with the sensitivity side and on the scenario side of things, this is, I’m not sure you described it this way, but this is where there’s a number of these, your base set of assumptions, your base case. This is moving a lot of them all at once. Right, so it’s interest rates can move, FX currency rates could move like you said of a base rate of something can move like your borrowing cost is based on SOFA or whatever. The scenario manages these or looks at these all changing at once, and that’s different from this pressure testing one unit at a time. That how you would you describe that? 

00:08:20 Paul Galloway 

Yeah, Craig. Scenario analysis is differerent in that respect, so you always start with your base case, but you’re always kind of wondering, you know, OK, if these particular events occur, which you know we’re looking at more than one variable with scenario analysis, we’re saying, hey, if these particular variables change either up or down or a particular variable doesn’t happen at all, or a new variable is introduced, what does that mean from a decision making standpoint? And as I noted earlier, we’re typically talking about what’s the financial impact that’s what a lot of these analyses are from a Treasury perspective. You know what are the financial impacts of these various scenarios that potentially could occur? And you know, like I talked about earlier in today’s environment, there are so many different things that are going on not only sensitivity analysis is more important, but the scenario analysis is more important because what you’re trying to do is be able to make good decisions around the particular analysis that you’re working on, so scenario analysis is an important tool in addition to sensitivity analysis. 

00:09:32 Craig Jeffery 

Yeah, very nice. I want to push on a couple of those things a little bit more to get a little deeper on those, so the idea of protecting the organization protection. Protection is a good term and it’s a bit of a set-up question. Is it protecting your organization is the avoidance of risk, is that the reduction in risk, is that the alignment of the risk appetite that the firm has, is it something else? 

00:09:59 Paul Galloway 

Yeah, it’s a great question Craig. And what I would say is it can be all those things and sometimes it can be multiples of those at the same time. When it comes to risk management and running scenario analysis and stevia analysis, it will allow you to determine you know OK, where does the risk lie? What variables really matter? Does it change my decisioning with potential changes out there and so you’re trying to get bandwidths of potential outcomes. Moving interest rates? I move them up I’m move them down. What’s that bandwidth of like? I run scenarios of introducing new variables, taking out variables and changing out key variables all at the same time. What does that mean? And so you’re trying to get a better understanding in terms of what potentially could happen and where the risk really lies, what variables really matter, and without doing these analyses you can’t, and so you can get with doing them, you can get one, you can get alignment of risk, meaning you align to what the risk appetite of the company is. You have elimination, you can eliminate risks, either it can be contractual or can be part of the structuring of the particular deal that you’re working on, that the analysis is for, or it can be risk mitigation in the sense that you’re trying to reduce risk but not completely eliminate it. So there can be things that you do again contractually in the structure that help mitigate some of those risks or lower them so it’s elimination, it’s reduction, it’s alignment. 

00:11:51 Craig Jeffery 

Yeah, excellent answer Paul. So you know, as we look at these scenarios you mentioned adding new variables or removing other variables. I’ll ask you for an option here and I’ll mention one client we did some risk management analysis with. One of the first functions or first activities was identifying their risk capacity or risk appetite and then unifying those elements that fell within that range that could variability could create a situation that pushed them out of the comfort range, so that would drive them to take some action to reduce the risk to keep it within their risk appetite. And since there’s a number of things calibrated, there’s certain items that fall in that range, and certain items that aren’t there yet or are very small. And so you know part of the process was monitoring those items that were growing and changing and identifying when they might become a bigger risk. So if you’re doing more business in a foreign currency, at some point, that could be any new variable that would be. One example might be commodities. Or maybe doing business in foreign country. Are there other ones that would you want to add in or other ones that you would take away would be examples of either of those or something else? 

00:13:11 Paul Galloway 

Yeah, Craig, when it comes to variables that will be monitored as treasurer. Obviously interest rates, inflation and foreign currency or items that would consistently be monitored. The other things that I would think about and from a capital management standpoint, the underlying benchmark, i.e., interest rates, treasury, SOFR, or otherwise. When you’re doing capital funding, there’s always spread component, which is tied to your organization’s rating. You know you’re Moody’s S&P, A.M. Best, depending on what kind of organization are, who’s doing ratings on you. Ratings, you know can have an impact on what your spread is, what also can have an impact is financial performance and how the market perceives the organization. So monitoring organization’s spreads compared to what’s going on in the market is really important, so you’re working to get data from bankers and other sources to be able to understand what the impacts are to capital funding or financing are particular items for an organization, so you definitely want to monitor those in addition to FX and interest rates, inflation. The other thing for consideration would be items that would have a direct impact on a company’s line of business or line of businesses. And so whether you know you’re a manufacturer, somebody that builds products or somebody that has a service, that’s how you distribute wherever it is that the business is known for and does, you want to bond or things that would impact the organization that way as well because that would have an impact on cash flow or projected cash flow outside of things that items that are already on the books. So from a forecast standpoint, you’re going to want to understand what are those key items that should be monitored on a regular basis and be part of your sensitivity analysis, scenario analysis, that you would do either for reporting purposes, forecasting purposes, or decision making when it comes to a particular project. Craig, one the other things for consideration would be, you know, in the risk management that we talked about just just a little bit ago, as a treasurer, often you’re engaged in hedging, so you might buy options or sell options depending on what you’re doing from a hedging standpoint to offset a perceived risk or to mitigate a perceived risk this out there and so, treasures often will engage hedging for interest rates and foreign currency, because it could have a direct impact on the business. So as I mentioned earlier, we talked about Capital Management or financing. You may do interest rate locks or an example, we can have an example of hey, we’re going to pay for something in foreign currency. We talked about euros and euros reaching parity. Well, movement with a stronger dollar relative to euro, we may want to hedge movement for whatever reason. It could be we’re paying foreign currency or we’re going to receive foreign currency. It could go either way. You may engage in an option to hedge any perceived risk in the movement of that currency at the time you go to strike a deal versus the point at what you actually pay cash to close the deal or receive cash for close of the deal. So options are something, a tool that treasures will use to manage risk. 

00:17:06 Craig Jeffery 

Yeah, excellent. I want to just mention a couple of those terms with those who may be newer to risk management or may not being financing. Just add to what I’m saying or correct me if I say something that’s not accurate. So optionality, for example, is, let’s say you have, you’re going to purchase something in a foreign currency in a month or two, or let’s say it’s a date certain two months from now, you might do a forward contract that fixes the price US to Swiss francs, for example, or euros, and so you set that. There’s no optionality to it, it’s just a future dated item. But let’s say you’re looking to close on a deal, but you don’t want to suffer currency moving against you, and you’re looking to buy a company that’s going to cost you 50 million. You want an option on that, for example, so that if it happens, I can pay and fix the rate, but if it doesn’t happen, I don’t have to buy the euros because I didn’t buy the company and so that’s a level of optionality, which is more complex because it’s more expensive and it’s volatile. That’s certainly a definition of optionality. Is that how you’re using it in this environment? 

00:18:25 Paul Galloway 

Yeah Craig, I alluded to earlier the idea of paying for something foreign currency or receiving something in foreign currency and trying to manage that risk. So as a treasure, you have the ability to go out and engage in, could be a forward contract, it could be an option to buy or sell something. In this case, we’re talking currency, so if you’re going to, say you’re going to pay for something in euros, for instance, you’re going to pay X million dollars or euros for something, and you want to hedge that risk. You’re not going to pay for it today, but you’re going to pay for it down the road. You engage in, buy an option to purchase euros at a certain price, you know, sometime in the future. It could be that it’s date specific, that happens on a certain date, or it could be paid between now and a particular date. I have the right or the option to purchase euros based on what we agreed to in the contract. If euros are moving in a certain direction that would be adverse to me, if I exercise the option, I’d be better off, meaning I pay less U.S. dollars to receive the same amount of euros then I’m better off having bought that option. Now there is a cost associated with an option, but as long as the cost of the option and the cost of paying for the euros is less than what the current market environment is, I’m better off. One of the things you can do as a treasurer when it comes to managing some of these, some of these risks using options is you may run simulations on interest rates or foreign currency to understand what the impacts are, potential impacts are, range of impacts are. You can have a model, you can have a set of key variables, you can set parameters around those variables, and run a simulation to see what outcomes might be and what I mean by simulation is, I used to use this as some number of years ago software package called Crystal Ball that allowed you to run Monte Carlo simulations where I could see what the impacts of changing variables given certain parameters put around those variables in a given confidence interval and desired distribution outcome, I could see what those impacts are and run thousand, 10,000 different scenarios or simulations of changing those variables based on the parameters I put into the system so that’s tied to a spreadsheet and see what the outcomes are, and these simulations can help you understand risks and where do you think things might end up landing. 

00:21:25 Craig Jeffery 

I’ve wanted to mention one other term you talked about, simulations and sensitivity stress testing, a particular variable or you must simulation, so the simulation is you said it could be multiple variables, so maybe it’s interest rates, maybe end inflation or maybe end FX and there’s a range of expectations for interest rates that that may be plugged into the model that go between these two ranges, and same thing with FX rates or whatever the variables are, and then this simulation is, it’s running those variations according to the model and all those numbers are being cycled in and out to give you multiple items tested at once. That’s what you’re referring to as the simulation, right? This automated running of multiple variants that are all changing within the designated ranges that you control in this scenario, or you’re running a simulation based upon the scenario and the model that you’ve put forth. 

00:22:30 Paul Galloway 

That’s right, Craig ’cause the simulations allow you to pressure test key variables that are tied to a particular analysis, and you can run a thousand, 10,000 simulations all at once. Well, not all at once, they’re happening, it seems to be, all at once. It happens over in a very short period of time. 

00:22:52 Craig Jeffery 

Seconds oftentimes, yeah. 

00:22:54 Paul Galloway 

With a lot of these softwares that are add-ins into Excel, you can actually see everything changing the distribution being built as the simulations are being run and you can see also the count on how many simulations have run at the particular time that you’re in, actually you could stop it if you wanted to, you could pause or pause the simulation and just take a look at what the outcomes are and then you could start it back up again, until it’s run the thousand, 10,000, or however many you told it to run. Yeah, and you can do that with setting up a certain range to each particular variable that’s of interest, so it could be interest rates, it could be spreads, it could be foreign currency rates, it could be inflation assumptions, it could be discount rates. It could be all kinds of different things that you could set parameters up around, and then you can tie a certain level of confidence, or it’s called a confidence interval, that’s tied to the distribution outcomes because you’ll have, you’ll get in the simulation, you’ll get some outliers. Something that will be like really negative and some will be really positive. That could distort where the most likely scenario is to land, and so you kind of want to throw those out with the confidence interval and so that allows you to do that in simulations. Then you can have them queued to the left or to the right, meaning that something could be more positive or more negative based on the parameters that you put in the model for running the simulations on key variables. 

00:24:42 Craig Jeffery 

Yeah, that’s excellent. You said something I thought was really, really important in terms of, you know, you said range that’s such an important concept in risk management. It’s, you know, we oftentimes get to this, well, what’s it going to be with interest rates are changing, you know, food prices, other commodities are moving, adjusting. What’s going to happen with the, you know currency strengthening, weakening, weakening, our changing business mix. There’s so many variables and people want to know what’s the number? And you basically said we run these scenarios to determine a range, and you use the term distribution. So what do you mean by range, as opposed to ,what’s the number? Paul, I want a number? Don’t give me a range, that’s hedging. But what does it say about how we manage risks or how a risk manager has to think? 

00:25:36 Paul Galloway 

Yeah, by running the simulations, given the current parameters that we put around key variables and running a confidence interval, what the range does is it tells us what the potential low outcome or negative outcome could be in with the potential upside or positive number can be. So you have top and bottom end, and so that’s the range, and the range depending on what the outcome curve looks like, will inform you given a certain confidence inveral most likely where the outcome will land and that helps you with decision making along the way. The ranges is really pretty important to understand because a single number by itself it tells you something but it doesn’t necessarily give you enough information to understand what really matters from a decision making standpoint, so getting a range understanding based on scenarios and sensitivities, running these simulation analysis they help you from a decision making standpoint. 

00:26:58 Craig Jeffery 

Yeah excellent yeah either prevent it or limit the range that it moves. This are great concepts. The next question I have for you is there’s different models. I think you talked about probability based, distributions. What are the three common ways of basing these scenarios simulations on how would you describe that? 

00:27:26 Paul Galloway 

There’s more than three, but there’s three that I found to be most common through my experience. The first model is a quantitative base model. We kind of talked about all three of these already, but didn’t really call them out, but the first would be quantitative. This would be a model that’s focused and based on particular key quantitative variables that can impact decision making or an outcome that impacts decision making. The other would be probability based, and so for key variables there’s, we set-up a certain probability that an outcome would happen, meaning that interest rates are X percent likely to be this, and you know the next set before interest rates it’s X percent for the next whatever the interest rate is so and so forth, so you’re putting probabilities around outcomes for key variables, tied to an analysis. The other one will be event driven and this has become more prevalent today. Why scenario analysis and sensitivity analysis is important because there’s lots of events that have happened in the past couple of years. You know COVID, Russia invading Ukraine, other things that have happened to disrupt supply distribution we’ve had a lot of different things have happened, most recently in the US, it’s inflation and so now interest rates are rising, so we have certain events that are happening that we need to run analysis to understand what those impacts are. So the three again are quantitative, probabilistic or probabilities, and then the other one is event driven. 

00:29:13 Craig Jeffery 

Yeah, pose, we draw to a close, I wanted to just ask you about accuracy. You know, as we run these models, there’s assumptions, there’s ranges, there’s a number of known variables, but elements that go into it, so maybe asking, does accuracy matter isn’t the right question, but how much accuracy matters? What would you say about accuracy of the? 

00:29:37 Paul Galloway 

That’s a great question, and I always tell anybody that is an analyst or runs a model that once you have an analysis completed, the only thing you really know is that it’s probably wrong. So the question is, is how wrong are you and what direction are you facing? What I’d like to do is with my analyses, when I run an analysis, I want to make sure I get myself to use a golf analogy, I want to make sure I’m in the fairway. So would I have an analysis with a set of outcomes, whatever analysis I’ve done, scenario analysis, sensitivity analysis, simulations, I want to be in the fairway, preferably in the middle of the fairway, meaning I’ve got the ball landed in the sweet spot of what the potential outcomes. The other thing I want is I want to be directionally correct. So I always think in terms of am I in the fairway, and am I directionally correct meaning I’m helping the decision maker make a decision that gets them to a favorable outcome. 

00:30:48 Craig Jeffery 

I think that the fairway model sounds great. You’re hitting it, you’re out of the rough, you’re into the fairway. But when you say directionally correct, that seems like you know some of these models could be positive or negative cash flow or whatever you’re testing for, could vary one side or the other. And so you know, I think in the fairways, like what if you hit it in the opposite direction. That can be the case with the distribution. I really like your fairway model the best. That captures this spread, this bell shaped curve, or whatever the shape of the curve is. I want to make sure I’ve got it right in the center. 

00:31:27 Paul Galloway 

Yes, fairway ,absolutely. Directionally correct is also important. And if I can give you an analogy that’s a real life example where I’ve run an analysis that showed that if we engage in a particular activity, it was most likely going to be a negative outcome, and so that’s an example of being directionally correct, the opposite way. And so sometimes we think about well directionally correct means that you’re heading towards the most advantageous thing. Well, it could be just the opposite that hey, if we go this particular direction, that will be disadvantageous. Well, we don’t want to go that way, so it helps you make a decision not to do something. So directionally correct is also important. 

00:32:16 Craig Jeffery 

Perfect I, I really like that explanation. Yeah, dead center fairway. Maybe you got it spot on the left or right of the curve. You’re still in the fairway until you’re in the rough, until you’re in the woods, until you hit your golfing partner who was sitting off to the side. Paul, this has been good fun. Thanks for your time and comments on scenario and sensitivity analysis. Really appreciate it. 

00:32:42 Paul Galloway 

Thanks Craig, been a great discussion as usual and look forward to the next one. 

00:32:48 Craig Jeffery 

Take care. 

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