Sensitivity Analysis
TYFM - Sem VI - R.M.
What Is Sensitivity Analysis?
• A sensitivity analysis determines how different values of an
independent variable affect a particular dependent variable under a
given set of assumptions.
• A sensitivity analysis determines how different values of an
independent variable affect a particular dependent variable under a
given set of assumptions.
• It is a way to predict the outcome of a decision given a certain range of
variables.
• Sensitivity analysis can be used to help make predictions in the share
prices of publicly-traded companies or how interest rates affect bond
prices.
• Sensitivity analysis allows for forecasting using historical, true data.
• By studying all the variables and the possible outcomes, important
decisions can be made about businesses, the economy, and about
making investments.
• Both the target and input—or independent and dependent—variables
are fully analyzed when sensitivity analysis is conducted.
• Sensitivity analysis can be used to help make predictions in the share
prices of public companies.
• So the variables like company earnings, the number of shares
outstanding, the debt-to-equity ratios (D/E), and the number of
competitors in the industry can affect stock prices .
• This model can also be used to determine the effect that changes in
interest rates have on bond prices.
• In this case, the interest rates are the independent variable, while
bond prices are the dependent variable.
Sensitivity Analysis of Equity Shares
• Following factors affect equity price :
Fundamental Factors
Technical Factors
Market Sentiment
Market Sentiments
• I.e. psychology of market participants individually or collectively
• Market sentiments are always subjective, Biased and obstinate
• assumption here is markets are apparently not efficient much of the
time
Sensitivity of Bond Prices
• Foowing Factors affect Bond Prices :
Interest Rate / Inflation
Credit Ratings
Reinvestment Risk
Interest Rate / Inflation
• when interest rates rise, bond prices fall. When interest rates fall,
bond prices rise.
• when inflation is on the rise, bond prices fall.
• When inflation is decreasing, bond prices rise.
• That’s because rising inflation erodes the purchasing power of what
you’ll earn on your investment.
• In other words, when your bond matures, the return you’ve earned
on your investment will be worth less in today’s value.
Credit ratings
• Credit rating agencies assign credit ratings to bond issuers and to
specific bonds.
• A credit rating can provide information about an issuer’s ability to
make interest payments and repay the principal on a bond.
• In general, the higher the credit rating, the more likely an issuer is to
meet its payment obligations.
• If the issuer’s credit rating goes up, the price of its bonds will rise.
• If the rating goes down, it will drive their bond prices lower.
Reinvestment Risk
• This risks exists only for bonds with call option.
• Here the issuer has the right to redeem the bonds before maturity.
• With decline in interest rates, prices of bonds with call option also
falls
• In case of falling interest rate scenario, issuers find it profitable to
redeem existing bond and issue new bonds with lower coupon rate.
• Hence investors of callable bonds will be compelled to make
investments in low coupon bearing securities.
Duration
• Price sensitivity tends to increase with time to
maturity
• Duration measures a bond’s sensitivity to interest
rate changes.
• More specifically, duration is a weighted average of
individual maturities of all the bond’s separate cash
flows.
• The weight is the present value of the payment
divided by the bond price.
• If a bond has duration of 10 it also means that
price sensitivity of bond is same as that of 10 year
zero coupon bond
12
Duration :
• Duration =
• Price if yield declines - Price if yield rises
2 × (Initial Price) × (Change in yield decimal )
Effective Duration
• It is duration calculation for bonds with embedded option
• It takes into consideration change in cash flow with change in interest
rate
• It is more suitable for measuring sensitivity of bond with embedded
option.
Convexity
• In finance, bond convexity is a measure of the non-linear relationship
of bond prices to changes in interest rates,
• It is the second derivative of the price of the bond with respect to
interest rates (duration is the first derivative).
Convexity
• As interest rates increase, bond yields increase, and consequently,
bond prices decrease.
• Conversely, as interest rates fall, bond yields fall and bond prices rise.
• If Bond A has a higher convexity than Bond B, which indicates that all
else being equal, Bond A will always have a higher price than Bond B
as interest rates rise or fall.
Sensitivity of option Premium
There are five fundamental parameters on which the option
price depends:
1) Spot price of the underlying asset
2) Strike price of the option
3) Volatility of the underlying asset’s price
4) Time to expiration
5) Interest rates
Spot price of the underlying asset
Price of underlying Value of call option Value of put option
asset
Increases Increases Decreases
Decreases Decreases Increases
02/27/2023
Strike Price
Strike Price Value of call option Value of put option
Increases Decreases Increases
Decreases Increases Decreases
Volatility of underlying Asset
Volatility of Value of call option Value of put option
underlying asset
Higher Higher Higher
Lower Lower Lower
Time to expiration
Time to Value of call option Value of put option
Expiration
Longer the Maturity Higher Higher
Shorter the Maturity Lower Lower
Interest rates
Interest Rates Value of call option Value of put option
Higher Increase Decrease
Lower Decrease Increase
Option Greeks
• Option premiums change with / sensitive to changes in the factors
that determine option pricing
• The sensitivities most commonly tracked in the market are known
collectively as “Greeks”
Delta (δ or Δ)
• This measures the sensitivity of the option value to a
given small change in the price of the underlying asset.
• It may also be seen as the speed with which an option
moves with respect to price of the underlying asset.
• Delta = Change in option premium/ Unit change in price
of the underlying asset.
• Delta for call option buyer is positive. This means that
the value of the contract increases as the share price
rises. (it is rather like a long or ‘bull’ position in the underlying asset )
• Delta for call option seller will be same in magnitude
but with the opposite sign (negative).
Delta (contd.)
• Delta for put option buyer is negative.
• The value of the contract increases as the share price
falls (This is similar to a short or ‘bear’ position in the underlying asset)
• Delta for put option seller will be same in magnitude but
with the opposite sign (positive).
• Therefore, delta is the degree to which an option price
will move given a change in the underlying stock or
index price, all else being equal.
• The knowledge of delta is of vital importance for option
traders
Delta (contd.)
• The delta is often called the hedge ratio,
e.g. if you have a portfolio of ‘n’ shares of a stock then ‘n’ divided
by the delta gives you the number of calls you would need to be
short (i.e. need to write) to create a hedge.
• In such a “delta neutral” portfolio, any gain in the value of the
shares held due to a rise in the share price would be exactly offset
by a loss on the value of the calls written, and vice versa.
Gamma (γ)
• Gamma = Change in an option delta/ Unit change in price of underlying asset
• It measures change in delta with respect to change in price of the underlying asset.
• A second derivative option with regard to price of the underlying asset.
• Calculated as the ratio of change in delta for a unit change in market price of the
underlying asset.
• it signifies the speed with which an option will go either in-the-money or out-of-
the-money due to a change in price of the underlying asset.
Theta (θ)
• Theta = Change in an option premium/ Change in time to expiry
• It is a measure of an option’s sensitivity to time decay.
• Theta is the change in option price given a one-day decrease in time to expiration.
• Usually theta is negative for a long option, whether it is a call or a put.
• options tend to lose time value each day throughout their life. This is due to the
fact that the uncertainty element in the price decreases.
Theta (θ)
• Theta = Change in an option premium/ Change in time to expiry
• It is a measure of an option’s sensitivity to time decay.
• Theta is the change in option price given a one-day decrease in time to expiration.
• Usually theta is negative for a long option, whether it is a call or a put.
• options tend to lose time value each day throughout their life. This is due to the
fact that the uncertainty element in the price decreases.
Rho (ρ)
• Rho = Change in an option premium/ Change in cost of funding the
underlying
• Rho is the change in option price given a one percentage point change
in the risk-free interest rate.
• Rho measures the change in an option’s price per unit increase in the
cost of funding the underlying.
Hypothesis of Market - EMH
• Forms of EMH
Weak form of EMH
Semi-strong form EMH
Strong form EMH
Forms of the EMH - Weak
•Prices reflect all relevant information
The relevant information is historical data such as past prices
and trading volume.
If the markets are weak form efficient, use of such information
provides no benefit at the margin.
Forms of the EMH - Semi-strong
The relevant information is "all publicly available information,
including the past data and information just released to the
public."
If the markets are semi-strong form efficient, then studying
earnings and growth forecasts and reacting to news provides no
net benefit in predicting price changes at the margin.
Forms of the EMH - Strong
The relevant information is “all information” both public and
private or “insider” information.
If the markets are strong form efficient, use of any information
(public or private) provides no benefit at the margin.
'Porter's five forces analysis
• It is a framework for industry analysis and business strategy
development formed by Michael E. Porter in 1979.
• It draws upon industrial organization (IO) economics to derive five
forces that determine the competitive intensity and therefore
attractiveness of a market.
• Attractiveness in this context refers to the overall industry
profitability.
• An "unattractive" industry is one in which the combination of these
five forces acts to drive down overall profitability.
Five forces
Threat of substitute
Threat of new Bargaining power
products or
competition services
of customers
Bargaining
power of
customers
Intensity of
Bargaining power
competitive
of suppliers
rivalry
1.Threat of new competition
• Profitable markets that yield high returns will attract new firms.
• This results in many new entrants, which eventually will decrease
profitability for all firms in the industry.
• Factors that can block Entry of new firms
• The existence of barriers to entry (patents, rights, etc.)
• Switching costs or sunk costs
• Capital requirements
• Access to distribution
• Customer loyalty to established brands
Threat of substitute products or services
• The existence of products outside of the realm of the common
product boundaries increases the propensity of customers to switch
to alternatives.
• For example, Pepsi is not considered a substitute for Coke but water,
tea, coffee, and milk are.
• Factors that can easily replace material products are -
Threat of substitute products or services
• Buyer propensity to substitute
• Relative price performance of substitute
• Buyer switching costs
• Number of substitute products available in the market
• Ease of substitution.
Bargaining power of customers (buyers)
• The ability of customers to put the firm under pressure
• It also affects the customer's sensitivity to price changes.
• Factors responsible are -
• Buyer concentration to firm concentration ratio
• Degree of dependency upon existing channels of distribution
• Buyer volume
• Buyer switching costs relative to firm switching costs
• Buyer information availability
• Availability of existing substitute products
Bargaining power of suppliers
• The bargaining power of suppliers is also described as the market of
inputs.
• Suppliers of raw materials, components, labor, and services to the
firm can be a source of power over the firm, when there are few
substitutes.
• Suppliers may refuse to work with the firm, or, charge excessively high
prices for unique resources.
• Factors responsible are -
• Supplier switching costs relative to firm switching costs
• Degree of differentiation of inputs
• Presence of substitute inputs
• Strength of distribution channel
• Supplier concentration to firm concentration ratio
• labor unions
• Supplier competition - ability to forward vertically integrate and
cut out the buyer
Intensity of competitive rivalry
• Sustainable competitive advantage through innovation
• Competition between online and offline companies
• Level of advertising expense
• Powerful competitive strategy
