Sensitivity

Sample Model
2005-2007 Copyright.
Dr. Johnathan Mun.
All Rights Reserved.

Tornado, Spider and Sensitivity Charts (Nonlinear)

This sample model illustrates how to use Risk Simulator (Enterprise Simulator) for:
1. Running a pre-simulation sensitivity analysis (Tornado and Spider Charts)
2. Running a post-simulation sensitivity analysis (Sensitivity Charts)
Model Background
File Name: Tornado and Sensitivity Charts (Nonlinear).xls
This example illustrates a simple option valuation model and shows how sensitivity analysis can be performed prior to running a simulation
and after a simulation is run. Tornado and Spider charts are static sensitivity analysis tools useful for determining which variables impact the key
results the most. That is, each precedent variable is perturbed a set amount and the key result is analyzed to determine which input variables are
the critical success factors with the most impact. In contrast, sensitivity charts are dynamic, in that all precedent variables are perturbed together
in a simultaneous fashion (the effects of autocorrelations, cross-correlations, and interactions are all captured in the resulting sensitivity chart).
Therefore, a Tornado analysis is done before a simulation whereas a Sensitivity analysis is done after a simulation.
Creating a Tornado and Spider Chart
To run this model, simply:
1. Go to the Black-Scholes Model worksheet and select the Black-Scholes result (cell E13).
2. Select Simulation l Tools l Tornado Analysis (or click on the Tornado Chart icon).
3. Check that the software's intelligent naming is correct for the precedent values.
4. Change the upper and lower test values from 10% to 80% on all variables and click OK.

Interpreting the Results

The report generated illustrates the sensitivity table (starting base value of the key variable as well as the perturbed values and the precedents).
The precedent with the highest impact (range of output) is listed first. The Tornado chart illustrates this analysis graphically. The Spider chart
performs the same analysis but also accounts for nonlinear effects. That is, if the input variables have a nonlinear effect on the output variable, the
lines on the Spider chart will be curved. Notice that the stock price and strike price have the highest effects (positive and negative effects,
respectively) and the inputs are nonlinear. Positively sloped lines indicate positive relationships, while negatively sloped lines indicate negative
relationships. The steeper the slope of the line, the higher the impact on the bottom line value.
In this special case where the option pricing model is nonlinear, you will see that the Tornado chart is not symmetrical and the Spider chart has
a few lines that are curved. These are key characteristics of nonlinear models. This means that an X percentage change in one variable will not
always mean a Y percentage change in the forecast result. Identifying nonlinearities are important in understanding the variables in a model.

Copyright 2005-2007. Real Options Valuation, Inc. (www.realoptionsvaluation.com)

Creating a Sensitivity Chart

To run this model, simply:
1. Create a new simulation profile (Simulation l New Profile).
2. Set some assumptions on the inputs (with correlations) and set the output forecast.
3. Run the simulation (Simulation l Run Simulation).
4. Select Simulation l Tools l Sensitivity Analysis.
Interpreting the Results
Notice that if correlations are turned off, the results of the Sensitivity chart is similar to the Tornado chart. Now, reset the simulation, and
turn on correlations (select Simulation l Reset Simulation, then select Simulation l Edit Profile and check Apply Correlations, then Simulation l
Run Simulation), and repeat the steps above for creating a Sensitivity chart. Notice that when correlations are applied, the resulting analysis
may be slightly different due to the interactions among variables. Notice that when correlations are turned on, the Stock Price position is reduced
to a less prominent effect as it is correlated to Dividend Yield, a less dominant variable. Note that in the Sensitivity chart, Volatility has a larger
effect once the interactions among variables have all been accounted for. Volatility in real life is a key indicator of option value and the analysis
here proves this fact.
Disclaimer
DEVELOPER SPECIFICALLY DISCLAIMS ALL OTHER WARRANTIES, EXPRESS OR IMPLIED, INCLUDING, BUT NOT LIMITED TO, THE IMPLIED WARRANTIES OF
MERCHANTABILITY AND FITNESS FOR A PARTICULAR PURPOSE. As standard practice for software development and end-user applications, it is important for the
Licensee to note that the valuation results attached herein are accurate to the software Developers best knowledge and are solely based on the information furnished by the
Licensee or end-user. While the software Developer has used his best efforts in preparing this report, he makes no representations or warranties with respect to the
accuracy or completeness of the contents of this model and specifically disclaims any implied warranties of merchantability of fitness for a particular purpose. The Licensee
hereby agrees that the Developer is not held liable for any loss of profit or any other commercial damages, including, but not limited to, special, incidental, consequential or
other damages. This model is only an illustration of using the software and in no way represents the correct and complete picture of an investor's investment, risk, and return
profile. The user is advised to take great care in using and interpreting the model and its results. Model was developed by Dr. Johnathan Mun of
www.realoptionsvaluation.com.

Copyright 2005-2007. Real Options Valuation, Inc. (www.realoptionsvaluation.com)

Generalized Black-Scholes Model

Stock Price
Strike Price
Maturity in Years
Risk-free Rate
Annualized Volatility
Dividend Yield
Black-Scholes Result

qT

Call=Se

$100.00
$100.00
5.00
5.00%
25.00%
2.00%
$25.48
2

ln( S/ X )+( rf q+ /2 )T
ln( S / X )+( rf q / 2)T

Xerf (T )
T
T

Copyright 2005-2007. Real Options Valuation, Inc. (www.realoptionsvaluation.com)

Tornado and Spider Charts

Statistical Summary

One of the powerful simulation tools is the tornado chartit captures the static impacts of each variable on the outcome of the model. That is, the tool automatically perturbs each
precedent variable in the model a user-specified preset amount, captures the fluctuation on the models forecast or final result, and lists the resulting perturbations ranked from the most
significant to the least. Precedents are all the input and intermediate variables that affect the outcome of the model. For instance, if the model consists of A = B + C, where C = D + E, then
B, D, and E are the precedents for A (C is not a precedent as it is only an intermediate calculated value). The range and number of values perturbed is user-specified and can be set to test
extreme values rather than smaller perturbations around the expected values. In certain circumstances, extreme values may have a larger, smaller, or unbalanced impact (e.g.,
nonlinearities may occur where increasing or decreasing economies of scale and scope creep occurs for larger or smaller values of a variable) and only a wider range will capture this
nonlinear impact.

A tornado chart lists all the inputs that drive the model, starting from the input variable that has the most effect on the results. The chart is obtained by perturbing each precedent input at
some consistent range (e.g., 10% from the base case) one at a time, and comparing their results to the base case. A spider chart looks like a spider with a central body and its many legs
protruding. The positively sloped line indicates a positive relationship, while a negatively sloped line indicates a negative relationship. Further, spider charts can be used to visualize linear
and nonlinear relationships. The tornado and spider charts help identify the critical success factors of an output cell in order to identify the inputs to simulate. The identified critical variables
that are uncertain are the ones that should be simulated. Do not waste time simulating variables that are neither uncertain nor have little impact on the results.

Result
Base Value: 25.4786764688884
Precedent Cell
Stock Price
Strike Price
Annualized Volatility
Maturity in Years
Risk-free Rate
Dividend Yield

Output
Downside
0.0287306
74.912288
12.994074
11.123762
18.190168
30.997461

Output
Upside
87.665051
7.6196425
39.051155
32.718244
33.439471
20.725439

Effective
Input
Range
Downside
87.64
$20.00
67.29
$20.00
26.06
5.00%
21.59
1.00
15.25
1.00%
10.27
0.40%

Input Changes
Input
Upside
$180.00
$180.00
45.00%
9.00
9.00%
3.60%

Base Case
Value
$100.00
$100.00
25.00%
5.00
5.00%
2.00%

Sensitivity Analysis
Statistical Summary
Sensitivity charts are dynamic perturbations created after the simulation run. Sensitivity charts are dynamic perturbations in the sense that multiple assumptions are perturbed
simultaneously and their interactions are captured in the fluctuations of the results. In contrast, Tornado charts are static perturbations, meaning that each precedent or
assumption variable is perturbed a preset amount and the fluctuations in the results are tabulated. Tornado charts therefore identify which variables drive the results the most
and hence are suitable for determining which variables to simulate (that is, they are used before a simulation), whereas sensitivity charts identify the impact to the results
when multiple interacting variables are simulated together in the model (that is, they are used after a simulation).
The Nonlinear Rank Correlation charts indicate the rank correlations between each assumption and the target forecast, and are depicted from the highest absolute value to
the lowest absolute value. Positive correlations are shown in green while negative correlations are shown in red. Rank correlation is used instead of a regular correlation
coefficient as it captures nonlinear effects between variables. In contrast, the Percent Variation Explained computes how much of the variation in the forecast variable can be
explained by the variations in each of the assumptions by itself in a dynamic simulated environment. These charts show the sensitivity of the target forecast to the simulated
assumptions.

Copyright 2005-2007. Real Options Valuation, Inc. (www.realoptionsvaluation.com)

Sensitivity Analysis
Statistical Summary
Sensitivity charts are dynamic perturbations created after the simulation run. Sensitivity charts are dynamic perturbations in the sense that multiple assumptions are perturbed
simultaneously and their interactions are captured in the fluctuations of the results. In contrast, Tornado charts are static perturbations, meaning that each precedent or
assumption variable is perturbed a preset amount and the fluctuations in the results are tabulated. Tornado charts therefore identify which variables drive the results the most
and hence are suitable for determining which variables to simulate (that is, they are used before a simulation), whereas sensitivity charts identify the impact to the results
when multiple interacting variables are simulated together in the model (that is, they are used after a simulation).
The Nonlinear Rank Correlation charts indicate the rank correlations between each assumption and the target forecast, and are depicted from the highest absolute value to
the lowest absolute value. Positive correlations are shown in green while negative correlations are shown in red. Rank correlation is used instead of a regular correlation
coefficient as it captures nonlinear effects between variables. In contrast, the Percent Variation Explained computes how much of the variation in the forecast variable can be
explained by the variations in each of the assumptions by itself in a dynamic simulated environment. These charts show the sensitivity of the target forecast to the simulated
assumptions.

Copyright 2005-2007. Real Options Valuation, Inc. (www.realoptionsvaluation.com)