Crucial Analytics-
Approach
The application of stochastic analysis to commercial risk is very different from simple speculative forecasts or stress testing.
The essence of this approach is first to identify the real sources of uncertainty in a situation and then to explore their whole range of likely values over time. This uncertainty should be associated with data that can be assessed or observed directly with a scatter based on historical observations.
A Specific Model
This may be constructed around the above considerations to express the overall uncertainty in the values on which decisions will be based.
This may be done using the uncertainties observed in different strands of data. The model should combine all the main sources of risk and distinguish between the continuous fluctuations in a constantly changing environment (stochastic components) and individual impacts of isolated events (probabilistic components). These processes may be linked as the system response to an event will often be conditioned by the prevailing environmental situation.
The risk attached to a situation is based on both its probability and its impact.
This is not the same as stress testing where the impact may be determined but the probability is not usually known.
Stochastic Component -
Background Environment
The continuously changing background environment is usually controlled by a few key parameters which may be presented through forecasts.
The uncertainty in these forecasts can be expressed through volatilities, which can often be determined from historical data. The forecast is applied through a stochastic process which examines the environmental uncertainty in which the specific model operates.
This approach is generic and can be applied to many and varied situations.
The analysis tracks the progress of the specific model through a range of different environmental possibilities.
Probabilistic Component-
Specific Events
Most specific models incorporate particular events that could have an impact on the process under inspection.
Once again, examination of a wide range of real life examples can provide a good indication of the relationship between the probability and impact of these events under the conditions that prevail at that time.
Risk
In the context of this analysis, the risk depends on the subtle interaction between the probability of an event occurring and the prevailing environmental conditions.
The output from the model must include the values on which the critical decisions are based in order to allow that risk to be evaluated.
From this starting point and armed with the best available knowledge of the process being examined, the Crucial method can be applied to almost any activity that involves the time evolution of risk from a set of starting parameters whose values are currently known, and which can be observed and measured over time.