Question

a) Explain what sensitivity analysis is giving examples of how a financial institution will use it. Discuss the difference between sensitivity analysis and scenario analysis.

Answer 1

Sensitivity Analysis : Through this process any organization can found out what impact will changes in one variable will have on the output of the model. When this is done, only one variable is varied while other are constant.
A Financial Institution can use this analysis in multiple areas. For e.g a mutual fund may want to check the impact of the interest rate increase by the federal bank in its portfolio as it has multiple debt instruments.

Unlike Sensitivity Analysis, in Scenerio analysis, multiple variables change and the outcome of the model is evaluated under different conditions. For e.g a similar mutual fund might want to do a scenerio analysis at various levels of Inflation in the economy, varying foreign exchange rates, varying stock exchange returns and at different interest rate levels with all the variables changing in the scenerios.

Needless to say scenerio analysis is a more complex analysis compared to sensitvitiy analysis.