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. The objective is 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. The discount rate is an important factor in deriving the theoretical value of stocks. Also on a macro level, changes in economic growth and inflation rates are influential on the value of stocks and bonds. Sensitivity analysis is also conducted on a micro level. A company may want to know the sensitivity of its revenues to a product price change, for example.
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 bond price decreases/increases 4% for every 1% increase/decrease in interest rate. A bond with a long maturity and low coupon has a longer duration and therefore is more sensitive to rate fluctuations. Buying a bond at a low interest rate means the bond will be less valuable when rates rise and other bond yields are higher. This is simply because fixed income investors will buy the higher-yielding bond, all else equal. Assets that are considered fixed income-like such as utility stocks and preferred stocks are two examples of rate-sensitive assets.
Benefits of Sensitivity Analysis
Sensitivity analysis helps determine how stock and bond valuations move with changes in key variables. An investor needs to determine how certain 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 desired 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. Sensitivity analysis is at the heart of risk models. A wide array of modelers in the banking and insurance sectors rely on running multiple changes of variables in their models to see results of 'what-if' scenarios. Across all other corporate industries, treasury and finance departments are increasingly being required to disclose sensitivity analysis or other risk measurement in financial statements.