Challenges and Pitfalls of Economic Scenario Generation

By Svetlana Borovkova, Head of Quantitative Modelling

Economic Scenario Generators are tools that simulate future paths of economic, financial and market variables. They are essential to many applications, for instance in investment and asset management. These generators evaluate the performance of investment portfolios under a multitude of plausible economic scenarios and reveal potential risks.

The Economic Scenario Generators used in asset management must provide future simultaneous paths of interest rates, equity markets and possibly other asset classes (high-yield investments, commodities and others). Time horizons for the required simulated paths can be quite long. For pension funds, for instance, these must extend 30 years or more into the future.

Outcomes from these generators need to cover the full range of future scenarios. They must give realistic distributions of financial variables (for instance interest rates or equity returns) at the required (possibly long) time horizon. This means that unlikely but plausible outcomes also need to feature in the scenario set, as these are typically responsible for tail risks.