Scenario Analysis

The expected cash flows that we use to value risky assets can be estimated in one of two ways. They can represent a probability-weighted average of cash flows under all possible scenarios, or they can be the cash flows under the most likely scenario. The former is the more precise measure, but it is seldom used simply because it requires far more information to compile. In both cases, there are scenarios in which the cash flows will be different from expectations—higher than expected in some and lower than expected in others. In scenario analysis, we estimate expected cash flows and asset value under various scenarios, with the intent of getting a better sense of the effect of risk on value. In this section, we first consider ...

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