Loading the player...

What is a 'Sensitivity Analysis'

A sensitivity analysis determines how different values of an independent variable affect a particular dependent variable under a given set of assumptions. This technique is used within specific boundaries that depend on one or more input variables, such as the effect that changes in interest rates (independent variable) has on bond prices (dependent variable).

BREAKING DOWN 'Sensitivity Analysis'

Sensitivity analysis is also referred to as "what-if" or simulation analysis and is a way to predict the outcome of a decision given a certain range of variables. By creating a given set of variables, an analyst can determine how changes in one variable affect the outcome.

Sensitivity Analysis Example

Assume Sue, a sales manager, wants to understand the impact of customer traffic on total sales. She determines that sales are a function of price and transaction volume. The price of a widget is $1,000, and Sue sold 100 last year for total sales of $100,000. Sue also determines that a 10% increase in customer traffic increases transaction volume by 5%, which allows her to build a financial model and sensitivity analysis around this equation based on what-if statements. It can tell her what happens to sales if customer traffic increases by 10%, 50% or 100%. Based on 100 transactions today, a 10%, 50% or 100% increase in customer traffic equates to an increase in transactions by 5%, 25% or 50%, respectively. The sensitivity analysis demonstrates that sales are highly sensitive to changes in customer traffic.

Sensitivity vs. Scenario Analysis

In finance, a sensitivity analysis is created to understand the impact a range of variables has on a given outcome. It is important to note that a sensitivity analysis is not the same as a scenario analysis. As an example, assume an equity analyst wants to do a sensitivity analysis and a scenario analysis around the impact of earnings per share (EPS) on the company's relative valuation by using the price-to-earnings (P/E) multiple.

The sensitivity analysis is based on the variables affecting valuation, which a financial model can depict using the variables' price and EPS. The sensitivity analysis isolates these variables and then records the range of possible outcomes. In a scenario analysis, on the other hand, the analyst determines a certain scenario, such as a stock market crash or change in industry regulation. He then changes the variables within the model to align with that scenario. Put together, the analyst has a comprehensive picture. He now knows the full range of outcomes, given all extremes, and has an understanding of what the outcomes would be given a specific set of variables defined by real-life scenarios.

RELATED TERMS
  1. Sensitivity

    Sensitivity is the magnitude of a financial instrument's reaction ...
  2. Interest Sensitive Assets

    Interest sensitive assets are assets held by a bank that are ...
  3. Expected Value

    The expected value is the anticipated value for a given investment ...
  4. Risk Analysis

    Risk analysis is the process of assessing the likelihood of an ...
  5. Negative Correlation

    A perfect negative correlation is a relationship between two ...
  6. Interest Sensitive Liabilities

    Interest sensitive liabilities are types of short-term deposits ...
Related Articles
  1. Investing

    Scenario Analysis Provides Glimpse Of Portfolio Potential

    This statistical method estimates how far a stock might fall in a worst-case scenario.
  2. Personal Finance

    How to Stress Test Your Financial Plan

    A look at four key variables and their impact on a financial plan.
  3. Investing

    What's the Correlation Coefficient?

    The correlation coefficient is a measure of how closely two variables move in relation to one another. If one variable goes up by a certain amount, the correlation coefficient indicates which ...
  4. Retirement

    Update Your Variable Annuity With Section 1035

    Thanks to a special tax code clause, you can surrender a variable annuity without paying income tax.
  5. Retirement

    Should Your 401(k) Be In An Annuity?

    Housing your retirement plan inside a variable annuity contract offers some big advantages, but only if you are close to retirement.
  6. Trading

    Basics Of Technical Analysis

    Learn how chartists analyze the price movements of the market. We'll introduce you to the most important concepts in this approach.
  7. Trading

    Sensitivity Analysis For Black-Scholes Pricing Model

    Trading options requires complex calculations, based on multiple parameters. Which factors impact option prices the most?
  8. Investing

    Fundamental Analysis for Traders

    Find out how the fundamental analysis method can be applied strategically to increase profits.
RELATED FAQS
  1. How Do Fixed and Variable Costs Affect the Marginal Cost of Production?

    Learn about the marginal cost of production and how it is affected by changes in fixed and variable costs. Read Answer >>
  2. How can I calculate break-even analysis in Excel?

    Learn what break-even analysis is and how to find the break-even point using the Goal Seek tool in Microsoft Excel using ... Read Answer >>
  3. How are fixed costs treated in cost accounting?

    Learn how fixed costs and variable costs are used in cost accounting to help a company's management with budgeting and controlling ... Read Answer >>
Trading Center