Reviewed by Oct 05, 2020| Updated on
Sensitivity is the extent of the response of a financial instrument to changes in its underlying factors. Such factors continuously influence financial instruments, such as stocks and bonds. Sensitivity accounts for all the factors that negatively or positively impact a given financial instrument's value. The goal is to learn the extent of variation. Sensitivity determines how an investment shifts as external factors fluctuate.
Stocks and bonds are particularly sensitive to variations in interest rates. The discount rate is a key factor in deriving a stock's theoretical value. Changes in economic growth and inflation levels also affect the valuation of stocks and bonds on a macro level. Examination of the response is also carried out on a micro-level. For example, a business might want to know the sensitivity of its sales to a shift in the product price.
Analyzing the sensitivity determines how stock and bond valuations move with the key variables. An investor must determine how certain variables will impact potential returns. Success criteria, a set of input values, a range over which the values can move. The minimum and maximum values for variables have to be preset to determine if the desired outcome has been achieved. An investor can make informed decisions about where to place assets while reducing risks and potential errors after determining profitability forecasts.
Sensitivity analysis is at the heart of risk models. A wide array of modellers 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 required to disclose sensitivity analysis or other risk measurements in financial statements.
Buying a bond at a low-interest rate means that if rates increase and other bond yields are higher, the bond will be less expensive. This is essential because investors with a fixed income are going to buy the higher-yielding stock, the rest being equal. Assets considered to be fixed income-like, such as utility stocks and preferred stocks, are two examples of assets that are rate sensitive.