SENSITIVITY ANALYSIS

Sensitivity Analysis is a tool used in financial modeling to analyze how the different values
of a set of independent variables affect a specific dependent variable under certain specific
conditions. In general, sensitivity analysis is the technique used to determine how independent
variable values will impact a dependent variable under a given set of assumptions. Its usage will
depend on one or more input variables within the specific boundaries, such as the effect that
changes in interest rates will have on a bond’s price.

Here is a general procedure to follow when conducting a thorough sensitivity analysis.

1. Determine which parameter(s) of interest might vary from the most likely estimated value.
2. Select the probable range and an increment of variation for each parameter.
3. Select the measure of worth.
4. Compute the results for each parameter, using the measure of worth as a basis.
5. To better interpret the sensitivity, graphically display the parameter versus the measure of
worth.

Advantages of Financial Sensitivity Analysis

There are many important reasons to perform sensitivity analysis:

 Sensitivity Analysis adds credibility to any type of financial model by testing the model
across a wide set of possibilities.
 Financial Sensitivity Analysis allows the analyst to be flexible with the boundaries within
which to test the sensitivity of the dependent variables to the independent variables. For
example, the model to study the effect of a 5-point change in interest rates on bond prices
would be different from the financial model that would be used to study the effect of a 20-
point change in interest rates on bond prices.
 Sensitivity analysis helps one make informed choices. Decision-makers use the model to
understand how responsive the output is to changes in certain variables. This relationship
can help an analyst in deriving tangible conclusions and be instrumental in making optimal
decisions.