What is 'Sensitivity'
Sensitivity is the magnitude of a financial instrument's reaction to changes in underlying factors. Financial instruments, such as stocks and bonds, are constantly impacted by many factors. Sensitivity accounts for all factors that impact a given instrument in a negative or positive way in an attempt to learn how much a certain factor impacts the value of a particular instrument.
BREAKING DOWN 'Sensitivity'
Sensitivity determines how an investment changes with fluctuations in outside factors. Stocks and bonds are especially sensitive to interest rate changes.
Interest rates are one of the most important underlying factors in the movement of bond prices and are closely watched by bond investors. These investors get a better idea of how their bonds will be affected by interest rate movements by incorporating sensitivity into their analyses.
Examples of Sensitivity
Fixed-income investments are very sensitive to interest rate changes. A bond's duration reflects changes in the bond's price for each 1% fluctuation of interest rate. For example, a bond with a duration of 4 means the value decreases 4% for every 1% change in interest rate. A bond with a long maturity and low coupon has a longer duration, is more sensitive to rate fluctuations and is more volatile in a changing market. Buying a bond at a low interest rate means the bond will be less valuable when rates rise and other bonds' yields are higher. Municipal bonds provide higher yields and are typically less sensitive to interest rate changes than corporate bonds.
Interest sensitive stock prices also vary with interest rate fluctuations. Large share price changes are seen with small rate changes. Stocks with large betas are extremely rate-sensitive. Utility stocks and some preferred stocks are two examples of price-sensitive stocks.
Benefits of Sensitivity Analysis
Sensitivity analysis helps determine uncertainties in stock valuation and reduce risks in a private or corporate portfolio. An investor needs to determine how the simplest changes in variables will affect potential returns. Criteria for success, a set of input values, a range over which the values can move, and minimum and maximum values for variables must be preset to determine whether a successful outcome has been reached. After determining profitability forecasts, an investor can make better-educated decisions regarding where to place assets while reducing risks and potential error.
Treasuries and finance departments are increasingly being required to disclose sensitivity analysis or other risk measurement in financial statements. Every public or private company needs a method to analyze risks and hedge against them appropriately.