Sensitivity analysis is performed to quantify the uncertainties. The main and greatest reason to perform sensitivity analysis in for stocks valuation is to mitigate the risk by calculating it. It is best when you need to work in the most uncertain market place however periodical sensitivity analysis can provide a room for comparison in the deviation in scenarios over the periods of time. If you have demanded risk premium using a model for example CAPM, you can further apply sensitivity analysis over it to justify the uncertainty prevailing in the market practices. It identifies the inherent standard errors in a model. Sometimes we encounter with unexpected returns, this is due to the same error inherent issue. Sensitivity analysis is basically a risk management tool that allows you a support so that you can mitigate risk associated to your portfolio. There are a number of reasons for what sensitivity analysis can worth to the stock traders. It can be used separately or with the combination of other risk management strategies such as calculation of Value at Risk (VAR). Deviations from the real output and a model output is measured through the Greek letters i.e., alpha, beta, gamma, Vega, Theata and rho. Importance of sensitivity analysis to a stock trader can be explained as follows:
- Risky Securities
Many high return yielding securities in the market have more risk associated with them. But sometime the noticeable risk is different from the real value of risk. The investors who seek to gain more from stock investors, most precisely here we are talking about the risk takers, can yield a better outcome by conducting a sensitivity analysis to view a better picture of the original scenario persisting in the market.
- Stock Valuation
In stock valuation, it is really important to monitor the real values of the stocks. Sensitivity analysis sometimes can allow an investor to make even abnormal returns if they find the over and undervalued securities and then drive the market to make the corrections of the mistakes. It is a frequently observed phenomenon that sensitivity analysis is not exercised by many of the investors. This is the reason for what market is leaned to make mistakes frequently in due course. However, repeatedly practice can make an investor even conscious to observe the scenarios by continuous learning.
- Macroeconomic Risks
Sensitivity analysis guides an investor to think in a bog picture. An investors if does not know about the way to conduct sensitivity analysis, he might use the pre calculated measures to justify the macroeconomic risks. Not only the individual investors, but also the companies conduct some sensitivity analysis at some stage to manage and mitigate the risk associated to the stocks and the portfolios.
Along with several benefits, sensitivity analysis has many pitfalls for stock traders as well. It is a complicated process which is difficult to calculate accurately by an individual stock trader. Because sensitivity analysis solely cannot work, it is a subsequent step to any mathematical model that stock traders are applying to measure the risk at first stage. In this comparison, VAR can work better because of simplicity and ease of use.