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).

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 Ham, 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
$1000, and Ham sold 100 last year for total sales of $100,000.Ham also determines that 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%
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-earning (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, such as 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 experience.

Sensitivity analysis works on the simple principle; Change the model and observe the behavior.
The parameters that one needs to note while doing the above are:
 A) Experimental design: It includes combination of parameters that are to be varied. This
includes a check on which and how many parameters need to vary at a given point in
time, assigning values (maximum and minimum levels) before the experiment, study the
correlation: positive or negative and accordingly assign values for the combination.
B) What to vary: The different parameters that can be chosen to vary in the model could be:
a) The number of activities
b) The objective in relation to the risk assumed and the profits expected
c) Technical parameters
d) Number of constraints and its limits
C) What to observe:
a) The value of the objective as per the strategy
b) Value of the decision variables
c) Value of the objective function between two strategies adopted

Measurement of Sensitivity Analysis

Below are the mentioned steps used to conduct sensitivity analysis:

1. Firstly the base case output is defined; say the NPV at a particular base case input value
(V1) for which the sensitivity is to be measured. All the other inputs of the model are
kept constant.
2. Then the value of the output at new value of the input (V2) while keeping other inputs
constant is calculated.
3. Find the percentage change in the output and the percentage change in the input.
4. The sensitivity is calculated by dividing the percentage change in output by the
percentage change in the input

This process of testing sensitivity for another input (say cash flows growth rate) while keeping
the rest of inputs constant is repeated till sensitivity figure for each of the inputs is obtained. The
conclusion would be that the higher the sensitivity figure, the more sensitive the output is to any
change in that input and vice versa.

Methods of Sensitivity Analysis

There are different methods to carry out the sensitivity analysis:

 Modeling and simulation techniques

 Scenario management tools through Microsoft excel

There are mainly two approaches to analyzing sensitivity

 1. Local Sensitivity Analysis: This is derivative based (numerical or analytical). The term
local indicates that the derivatives are taken at a single point. This method is apt for
simple cost functions, but not feasible for complex models, like models with
discontinuities do not always have derivatives. Mathematically, the sensitivity of the cost
function with respect to certain parameters is equal to the partial derivative of the cost
function with respect to those parameters. Local sensitivity analysis is one-to-a-time
(OAT) technique that analyzes the impact of one parameter function on the cost function
at a time, keeping the other parameters fixed.
2. Global Sensitivity Analysis: Is often implemented using Monte Carl techniques. This
approach uses a global set of samples to explore the design space. The various techniques
widely applied include:
 Differential Sensitivity analysis: It is also referred to the direct method. It involves
solving simple partial derivatives to temporal sensitivity analysis. Although this method
is computationally efficient, solving equations is intensive task to handle
 One at a time Sensitivity Measures: It is the most fundamental method with partial
differentiation, in which varying parameter values are taken one at a time. It is also called
local analysis as it is an indicator only for the addressed point estimates and not the entire
distribution.
 Factorial Analysis: It involves the selection of given number of samples for a specific
parameter and then running the model for the combinations. The outcome is the used
where one input parameter varies from minimum to maximum value.
 Correlation Analysis: Helps in defining the relation between independent and dependent
variables.
 Regression Analysis: Is a comprehensive method used to get responses for complex
models.
 Subjective Sensitivity Analysis: In this method the individual parameters are analyzed.
This is a subjective method, simple, qualitative and an easy method to rule out input
parameters

Using Sensitivity Analysis for Decision Making

One of the key applications of sensitivity analysis is in the utilization of models by managers and
decision-makers. All the content needed for the decision model can be fully utilized only through
the repeated application of sensitivity analysis. It helps decision analysts to understand the
uncertainties, pros and cons with the limitations and scope of a decision model. Most if not all
decisions are made under uncertainty. It is the optimal solution in decision making for various
parameters that are approximations. One approach to come to conclusion is by replacing all the
uncertain parameters with expected values and then carries out sensitivity analysis. It would be a
breather for a decision maker if he/she has some indication as to how sensitive will the choices
be with changes in one or more inputs.
Uses of Sensitivity Analysis

 The key application of sensitivity analysis is to indicate the sensitivity of simulation to

uncertainties in the input values of the model.
 They help in decision making
 Sensitivity analysis is a method for predicting the outcome of a decision if a situation
turns out to be different compared to the key predictions.
 It helps in assessing the riskiness of a strategy.
 Helps in identifying how dependent the output is on a particular input value. Analyses if
the dependency in turn helps in assessing the risk associated.
 Helps in taking informed and appropriate decisions.
 Aids searching for errors in the model.

Conclusion

Sensitivity analysis is one of the tools that help decision makers with more than a solution to a
problem. It provides an appropriate insight into the problems associated with the model under
reference. Finally the decision maker gets a decent idea about how sensitive is the optimum
solution chosen by him to any changes in the input values of one or more parameters.