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Lecture 04 : Uncertainty in Financial Markets : Idea of Hedging (Contd.) — Transcript

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0:01[Music]
0:22[Music]
0:27welcome to the next lecture we'll
0:30continue with uh the idea of hedging and
0:33uncertainty in financial
0:35markets in the last lecture we this is
0:39where we ended we looked at the payoff
0:42from a long call option that is if I buy
0:46a call
0:47option which has a strike price of
0:50e then at the expiration date this is my
0:54payoff where pce is the price of the
0:57call
0:58option great
1:01what if I go short on a call option that
1:03is what if I sell a call option to
1:06somebody else let's say to
1:08you then what is my
1:11payoff and let's say the strike price of
1:14the call option is
1:16e h so there are two
1:21possibilities
1:23either the price of the call option uh
1:26sorry the price of the underlying asset
1:28at expiration date which is S capital
1:31this becomes more than the call option
1:33the more than the strike
1:35price that is e+ 10 then what will
1:39happen well I have sold you the call
1:41option so what will you do now you have
1:44the right to buy this asset at rupees E
1:49from me on the expiration
1:52date okay and I am
1:54obligated to sell
1:57you one unit of this asset at rupees e
2:02on the expiration date but the price of
2:04the asset at the expiration date is e+
2:0610 let's say then what what will happen
2:09I will have to buy the asset from the
2:11market at e+ 10 and then give it to you
2:15and you will give me the strike price e
2:18so I will have a loss what is my loss
2:22what is my loss here it is
2:2410 so as the price of the asset goes
2:28up above the strike price e i the seller
2:33of the call
2:34option will start incurring
2:37losses higher the price of the asset
2:41higher my losses okay as you can see
2:44from this graph it is exactly opposite
2:48when I buy a call option when I buy a
2:50call option I really want the price of
2:52the asset to go up when I sell a call
2:54option my payoff decreases as the price
2:57of the
2:58asset goes up price of price of the
3:01underlying asset goes up of
3:04course when I sell a call option I also
3:07get some money because I'm selling it
3:10for some
3:12amount so the entire payoff moves up by
3:16this
3:18much so if the price is below E then
3:20what will happen so if St is below E so
3:24if St is less than e then what will
3:28happen well then you have the right to
3:30buy this underlying asset at Price e but
3:34the price of the underlying asset in the
3:36market is less than
3:38e so this right of buying at Price e is
3:42a useless right and you won't exercise
3:45this right I on the other hand I'm happy
3:49why because I will make this profit this
3:52much profit which is equal to the price
3:54of the call option you will not exercise
3:56the option so this is my profit once
3:59once the price starts going above E I
4:02start uh my profit starts getting eaten
4:05up and eventually I run into
4:08losses okay so this is the
4:11payoff uh if I if I'm seller of a call
4:17option
4:19okay now we'll start talking about
4:21something
4:23else consider
4:26uh again consider the TCS stock option
4:29and let's say it is it is trading at uh
4:31price
4:333416 and let's say tomorrow the election
4:36results will be declared and I feel uh
4:39that the TCS price will uh go up to 35
4:44so now I own a unit of TCS one one stock
4:48of
4:50TCS and after the election results I'm
4:52really hoping that the price of TCS will
4:55go up to
4:5835 so will I sell my TCS stock now at
5:033416 answer is no why should I I'm
5:06owning it I have it in my
5:08wallet I'm tempted to wait after the
5:11election results are
5:13declared I'm tempted to wait till the
5:15election results are declared and sell
5:16it after that so that I can sell it at
5:2135 but then I'm also
5:24fearful what is my fear I'm fearing that
5:28maybe there will be a hung assembly or
5:29something like that and the price will
5:31go down to
5:3333000
5:35okay so on one hand I'm tempted to wait
5:38on the other hand I'm fearful that uh
5:41the price will go down to 33000 which is
5:44lower than the current
5:47value okay so should I should I sell it
5:51now should I wait I'm caught in this
5:53dilemma so what do I want now what if
5:57somebody gives me an insurance or right
5:59which will allow
6:01me to sell this one unit of TCS at 3416
6:06which is the current
6:07price
6:09tomorrow so now my downside has been
6:12protected right I can't lose I I can
6:16today I can sell it for 3416 I'm fearful
6:19that I won't be able to sell it for 3416
6:21tomorrow if the price goes down but if
6:24somebody assures me that hey don't worry
6:27tomorrow as well you can sell it for 3
6:2941 6 no matter what then my fear is
6:33gone if the price goes to 35 fantastic I
6:37will sell it for
6:3935 if it goes down to 330 even then I
6:43can sell it for 3416 because I have this
6:47insurance okay now this insurance or
6:51right which allows me to sell one unit
6:54of TCS at
6:563416 on 1st of September or tomorrow
7:00this is called the put
7:03option
7:05okay so what was call option call option
7:09was a right to buy it was the right to
7:12buy an
7:14asset at a particular price called the
7:16strike price on the expiration date a
7:19put option on the other hand is a right
7:22to sell an
7:24asset at a particular price on the
7:26expiration
7:28date okay
7:30and just like in the previous scenario
7:32somebody who buys the option is said to
7:36go long on a put option somebody who
7:38sells the option is say is said to go
7:40short on a put
7:42option
7:45great so this is the formal definition a
7:47put option is uh denoted by
7:52P E is the strike price that is the
7:55amount the price at which I am ensured
7:59that I can
8:01sell at the expiration date denoted by
8:03capital T and S is the underlying
8:07asset okay
8:12fantastic now what's the
8:14payoff let's say I have bought a put
8:17option then what is my payoff how will
8:20my payoff look like of course I'm
8:22ignoring the price of the put option for
8:24for the time
8:25being so I have the right to sell one
8:29one unit of TCS or one unit of an asset
8:32at e
8:34Rupees at the expiration date okay fine
8:40now let's say the price of the asset St
8:44is less than e let's say it is e minus
8:505 okay
8:53then well I have the right to sell it at
8:56e
8:57rupees okay so let's let's say you have
9:01uh I have bought a put option from
9:04you so I have the right to sell one unit
9:07of the underlying asset to you at e
9:10rupees on the expiration date but let's
9:12say the price of the asset in the market
9:14is eus
9:155 so what is my payoff then well I will
9:19buy the asset from the market at e minus
9:225 then I will go to you and say hey see
9:26I have this put option I have the right
9:28to sell it to you at e rupees and I will
9:30sell it to you at e rupees you're
9:32obligated to buy from
9:33me okay and I will make a payoff of
9:37five if the price is eus 10 then I will
9:41buy from the market at eus 10 and sell
9:43it to you at e rupees again and my
9:45profit will be 10 so lower the price in
9:49the market higher my payoff if I am a
9:51owner of a put option if I bought a put
9:55option fantastic so lowered the price
9:58lowered the price higher The
10:02Profit
10:04okay great what if the
10:08uh payoff or sorry the price at price of
10:11the underlying asset at the expiration
10:13date what if it goes above e then what's
10:16going to
10:18happen well so let's say it becomes e+
10:2410 so now I have the right to sell one
10:27unit of this pen to to you at e+ at e
10:32rupes but in the market it can be sold
10:35at e+
10:3710 so this right to sell to you at e
10:40Rupees is a useless right I might as
10:43well go to the market and sell this pen
10:44at e+ 10
10:46Rupees so which means I will not
10:49exercise the put
10:50option and my payoff from the put option
10:53will be zero if the price is above e so
10:57this is how the payoff looks like so in
10:59this Zone the payoff is
11:04zero of course uh so this is
11:08when I'm assuming that the put option
11:10was free I'm not taking into account the
11:13price of the put option but if you take
11:15into account the price of the put option
11:17then long put means I'm buying the put
11:20so the entire
11:21payoff uh comes
11:23down by an amount PPE which is the price
11:27of the put option
11:34okay what about the payoff of the seller
11:36of a put
11:38option what happens
11:41then well uh let's say I sell you a put
11:45option it's exactly the opposite if I
11:49sell you the put option uh you have the
11:51right to sell the underlying asset to me
11:53at
11:54e if the price of the asset is above e
11:57then what will happen
12:00if the price of the asset at the
12:01expiration date is above e then what
12:03will happen well you won't exercise the
12:05put option the payoff is
12:08zero
12:09okay so nobody nobody there is no
12:12transaction
12:13happening if the price of uh the
12:16underlying asset at the expiration date
12:18is less than e let's say it is e eus
12:225 then what will happen then I will have
12:26to uh I have I have sold you the put
12:30right so you have the right to sell it
12:32to me at e
12:34rupees so I will have to buy it from you
12:37at e rupes and sell it in the Market at
12:40e minus 5 which means I will have a loss
12:43of 5
12:44rupes okay so lower the price greater my
12:49loss so you can see lower the
12:51price so this is the loss lower the
12:54price goes greater my
12:57loss okay
12:59so that's the payoff of a short put if I
13:02sell a put that's my
13:05payoff of course if I sell a put then I
13:09also get some money UPF front which is
13:11the price of the put so the entire
13:14payoff gets scaled up by an amount
13:17PPE which is the price of the
13:21put great so we have looked at call
13:24options and we have looked at put
13:26options we have looked at the payoff of
13:28some somebody who goes on goes long on a
13:30call or long on a put or short on a call
13:33or short on a
13:36put now we'll talk about another
13:38instrument in the financial Market which
13:40is called shorting an
13:42asset you can take a look at this video
13:45and then we'll come
13:52back so what did you see in the
13:55video in the video uh
13:59what uh herid is saying is the
14:02following what is shorting a
14:05stock well I don't own a stock so
14:08shorting a stock basically means selling
14:10a stock or selling an asset without
14:14owning
14:15it how can that happen in the following
14:21way
14:22if I so what I'm going to do is the
14:24following I will just call the
14:27broker and say
14:30that sell one unit of TCS
14:35stock what will the broker do the broker
14:38will take up a unit of TCS stock and
14:42sell it in the market and get some money
14:46and he'll give that money to
14:47me okay I get some money 100 rupees
14:50let's
14:52say now the broker will tell me that
14:55remember you owe me one unit of TCS
14:58stock I will say yes yes yes I
15:00remember so I have taken this 100 rupees
15:03I've kept it in my wallet and I'm
15:05waiting now if the price of TCS if it
15:09goes down to 10 rupees or let's say to
15:1390 rupees by 10 Rupees let's say so if
15:16the price of TCS stock goes down to 90
15:18rupees then what will I do I have 100
15:22rupees in my wallet which I got from the
15:23broker I will use 90
15:26Rupees to buy one unit of the T TCS
15:29stock and give it back to the broker
15:32because remember I owe one unit of TCS
15:34stock I will have to give it to the
15:36broker he sold it on my
15:38behalf so I will use the 90 rupes of the
15:41100 rupees which I have in my wallet to
15:43buy one unit of the TCS stock and give
15:46it back to the broker so now I I'm I'm
15:49clear I don't owe anything to
15:52anybody but in this entire Transaction
15:54what am I left with I am left with a
15:57profit of 10 Rupees
16:01right I had 100 rupees the broker sold
16:04one unit of TCS stock gave me 100
16:07rupees the TCS stock came down to 90
16:10rupe I bought the TCS stock at 90 rupes
16:13gave it back to the broker the broker's
16:15account is settled in the meanwhile I
16:18just made 90 rupees in between uh 10
16:21Rupees in between 100us
16:2390 okay so this is called shorting a
16:27stock so lower the the price of the
16:29stock
16:30becomes higher my
16:33profit okay so I got 100 rupees from the
16:36broker by shorting One stock of
16:39TCS but I had to Reby a stock of TCS
16:42later on to give it back to the
16:44broker if the lower the price of TCS
16:47later on higher my
16:50profit right so it's a downward sloping
16:54payoff
16:57curve and remember we are talking about
17:00like in call option and put option we
17:02had expiration date in case of shorting
17:05we have something called a settlement
17:07date okay so if the price of TCS is
17:11lower than 100 rupees on the settlement
17:13date then or on or before the settlement
17:17date then I'm going to make profit if it
17:19is higher then I will run into losses
17:22because anyway I'll have to buy a stock
17:24of TCS and give it back to the broker if
17:27it is at 110 I will have to to buy it at
17:29110 and give it back to the broker and
17:31then I will have a loss of 10
17:34Rupees
17:36great now let's try to be a little more
17:39sophisticated let's use we have looked
17:42at call Port shorting a stock now let's
17:45try to uh mix them up and create more
17:48complicated instruments let's start with
17:50a very easy one shorting with a
17:54call okay
17:57great so let's say current currently the
17:59price of an asset is s
18:01rupees so I
18:05uh shot a stock and get S rupes it's a
18:10downward curve as you can see this
18:14one but it can go go really down
18:18right so what I'm doing is as the uh I'm
18:23buying a call option so as the price of
18:26the stock goes up on the settlement date
18:29my payoff will become lower and
18:32lower and finally my losses will become
18:34huge so in order to mitigate that what
18:38am I
18:38doing I'm buying a call
18:42option which allows me
18:45to buy one unit of this underlying asset
18:49at e rupees and let's say the settlement
18:52date and the expiration date are
18:56coinciding okay okay so so what's what's
18:59happening
19:01here so as I have shorted the stock the
19:04payoff keeps coming down as the price
19:06goes
19:07up ideally the payoff should have come
19:10down further as the price gone up but
19:14since I have the call option what will I
19:17do if the price goes above
19:21e it doesn't matter I have the right to
19:25buy this asset at rupees e since I own
19:28the call
19:30option okay remember I'll have to pay
19:33the broker back one unit of the
19:34underlying asset and now I have the call
19:38option which allows me to buy the
19:40underlying asset at e
19:43rupees so no matter how much the price
19:46of the underlying asset goes up my loss
19:49can't exceed e
19:51rupees okay not not even EES rather I I
19:55will definitely be able to buy it at e
19:57rupes
19:59right
20:02fine that's the
20:07thing fine we have looked at different
20:10uh financial instruments let's look at
20:12one particular uh real life situation
20:17and let's try to understand investing or
20:19trading in
20:21tution well this is something which
20:23happened uh some time
20:25back which was uh a court case between
20:29uh
20:31Amazon and um the future
20:34group so basically Reliance was
20:37acquiring the future group and Amazon
20:41filed a
20:42case and the case was there uh initially
20:46uh in the Supreme Court and then in the
20:48Singapore uh International arbit
20:50arbitration
20:52Center so the thing was the
20:56following if the uh so Amazon was
20:58against the
21:01deal so if the Reliance future deal
21:04happens so let's say you are standing
21:06and you're reading this in the
21:08newspaper that a deal is supposed to
21:10happen between Reliance and
21:12future Reliance will acquire uh
21:17future but if uh Amazon manages to win
21:22the case then the deal won't happen or
21:24the deal might be delayed
21:27indefinitely so if the deal happens then
21:30the Reliance price will go
21:33up if the deal is
21:35terminated in the court then Reliance
21:39will take a beating and the price will
21:42go down right so let's say you reading
21:45this in the newspaper you are caught in
21:47this dilemma you don't know whether the
21:48price of Reliance will go up or go down
21:51so I don't really know what's going to
21:54happen but I know that something will
21:57happen whichever way the verdict goes
22:00the price of Reliance stock will either
22:02go up or go down based on this news
22:05based on the outcome of this uh court
22:09case so what should I
22:11do should I go should I buy a stock of
22:14Reliance no I'm fearful it might go down
22:18should I sh a stock of Reliance no I
22:21don't know if the code verdict is in
22:24favor of Reliance the stock price will
22:26go up then I will run into losses
22:29so what should I
22:31do right I'm I'm I I know that it can go
22:35either way and I know that it will go
22:38either this way or that way so what can
22:41I do can I still make money in this
22:43scenario can I have some trading
22:47strategy okay so let's use the following
22:51trading strategy which we can use in
22:52this situation let's see so what am I
22:55betting on here what am I hoping that
22:58will
23:00happen I'm basically betting on
23:05movement I'm hoping that the price of
23:08Reliance will surely go up or go down it
23:12won't stay or hover around where it is
23:16right now so I'm really hoping for some
23:20movement right either either up or down
23:23I don't
23:24know so I will do the following what do
23:27I do I will buy a call option and a put
23:33option which have the same expiration
23:36date and same strike
23:38price same expiration date and same
23:41strike
23:43price okay this strategy is called a
23:47straddle
23:49strategy okay so I'm buying a call
23:53option and a put option what is the
23:55underlying asset here the stock of the
23:59stock of Reliance One stock of Reliance
24:01that's my underlying
24:03asset
24:05okay now if if St that is the price of
24:10the stock underlying stock underlying
24:12asset if it is above e
24:15then which one will I exercise if the
24:18price of the underlying asset is above
24:21e the call option gives me the right to
24:24buy it at
24:26e so it is a worthwhile right
24:28and I will exercise the call option will
24:31I exercise the put option no if the
24:34price of the asset is above e and I have
24:37the right to sell it at e then it's a
24:40useless right because I might as well
24:42sell it in the Market at a price above e
24:45so if St is greater than E I will only
24:49exercise the call option by a symmetric
24:51argument if STD is less than E I will
24:54only exercise the put option
25:00now let's see what is my
25:02payoff what is my payoff if I buy a call
25:05and a put of course right now I'm
25:08ignoring the price of uh the the
25:12options let's
25:15see if the price of so what do I have I
25:20have a put option
25:23PE and I have a call option
25:30if the price of the underlying asset
25:33which is this this is
25:36St the price of the underlying asset on
25:39the expiration date if this goes
25:42above uh capital E what will
25:46happen well then I will exercise the
25:49call
25:50option let's it it becomes uh e+
25:545 then what will happen I will exercise
25:57the call option
26:00I will the Call option gives me the
26:03right to buy the asset at e
26:07rupees and then I will sell it off in
26:09the Market at e plus 5 rupees and make a
26:11profit of 5
26:13rupees as the price of the asset goes up
26:16my payoff goes up so it is this segment
26:19of the
26:20line okay so if it is above e in this
26:23zone I'm exercising the call option
26:31what if the price goes below E let's say
26:34it becomes eus
26:385 then of course I will exercise the put
26:40option as we saw in the previous
26:42Slide the put option gives me the right
26:46to sell the asset at e rupees so what
26:49will I do I will buy one unit of the
26:51asset from the market at eus 5
26:54rupees and then I will use the put
26:57option and sell the asset ass ET at for
26:59e rupes and thereby get a payoff of five
27:03so lower the price higher my profit in
27:07this segment so here I'm using the put
27:12option so we
27:15see higher my deviation from E higher my
27:21profit if I use the straddle
27:24strategy okay higher my deviation from E
27:27higher my
27:29profit and remember I was betting on
27:32movement I was hoping that uh the price
27:35will change and I will get some
27:39profit of course if we take the price of
27:42the options into account the entire I
27:45have bought a put option and a call
27:46option remember so I've spent some money
27:49so the entire entire payoff gets uh
27:52shifted down by an amount PE plus c
27:58okay so this is what it looks like so if
28:01e is the strike price which I'm buying
28:03at let's say this is the this is the
28:06zone so let's say this is e minus
28:09Epsilon e plus
28:13Epsilon so I'm hoping that the change in
28:16price will be will take the price of the
28:19Reliance stock above this
28:22either to the right of this band or to
28:25the left of this band so I'm hoping for
28:28for movement so straddle is is a trading
28:31strategy where you don't know whether a
28:34particular asset will go up or down but
28:37you know for sure that they will
28:39definitely go either significantly up or
28:42significantly down so here you are
28:44betting for movement but you don't know
28:47the direction of the
28:49movement great that's a
28:53straddle another uh
28:58different version if you may call it a
29:01little change here though is
29:04strangle here also I'm betting on
29:07movement but I also have a hunch about
29:10the
29:11direction let's see what that
29:14means so what am I doing here again I'm
29:17buying a call option and I'm buying a
29:20put
29:22option but in this case the strike price
29:26of the put option is l lesser than
29:29capitally which is the strike price of
29:31the call
29:32option
29:35okay so uh you can imagine what will be
29:37the payoff if the price of the
29:40underlying asset s of capital t is
29:42greater than capital E then I will
29:45exercise the call if it is less than
29:47small E I will exercise the
29:50put and if it lies between SMY and
29:52capitally I will not exercise either of
29:55the
29:56options if it's it's not clear to you
29:59pause the video and think about it for
30:01for a
30:04minute so this is how the payoff will
30:07look
30:10like so I've taken into account so this
30:13is exactly like straddle but we have a
30:17uh we have a plateau in between here
30:21straddle was straddle was sharp v-shaped
30:24but here we have a steady Zone
30:29right okay but why is strangle uh when
30:33is strangle used instead of strle
30:35straddle let's understand
30:40this if since the expiration uh sorry
30:44since the strike price of the put option
30:46which I'm buying in strangle is lower
30:49than that of
30:51straddle the price of the put option
30:53will also be
30:54lower see what is put option A put
30:57option
30:58is a right to sell an asset at some
31:03strike
31:04price so higher that strike price more
31:08precious that right is and hence higher
31:11the price of the put
31:13option right which means that the price
31:17of the put option in strangle is lower
31:20than the price of the put option which I
31:22buy in straddle so the strangle
31:24portfolio is cheaper than the straddle
31:26portfolio
31:28okay but I'm still here as well betting
31:31on movement if you if you see the uh
31:35payoff you can see that I really
31:39want the stock price to go above this
31:42band either go to the right of this or
31:44go to the left of
31:46this
31:51okay but I'm kind of betting on upward
31:54movement more let's see how
31:59assume that the stock is trading at 15
32:01rupees in
32:04April now suppose I have a call option I
32:07bought a call option which has a strike
32:09price of
32:1015 and expiration date is
32:14June and I buy a put option which has a
32:18strike price of 15 and expiration date
32:20is June so this is a
32:23straddle now if I buy 100 sized straddle
32:26it means what
32:29it means I'm buying 100 calls and 100
32:32puts okay now the each call option with
32:36strike price 15 is worth 2 rupees and
32:40each put option with a strike price 15
32:43is worth 1 rupe so what is the price of
32:45my straddle portfolio it's 300
32:48rupees okay that's the that's the uh
32:51amount which I have to spend to buy 100
32:54calls and 100 puts of this kind or 100
32:57straddles
33:00okay and the straddle value will
33:02increase as the stock moves higher or
33:06lower but the Prof when will The Profit
33:08be
33:10realized so you can imagine
33:13here so if it is 15 if 15 is my strike
33:22price and uh so I will have to
33:26basically make a profit of three to
33:29break even because one put and one call
33:32has cost me 3 rupees so I will really
33:35hope that the price goes above
33:3918 or below
33:4212 right either above 18 or below 12
33:46that's what I'm hoping
33:47for so I'm hoping for at least a
33:50movement of three this is my straddle
33:54scenario and the straddle has no
33:56directional bias where whether it moves
33:58by an amount above three in the
34:00rightward direction or leftward
34:02Direction I don't care I will make
34:06profits now in the strangle what I'm
34:09doing is the
34:11following I'm buying a call option again
34:14with a strike price of
34:1615 but now I'm buying a put
34:20option with a strike price of 12.5
34:24instead of
34:2615 instead of buying a put
34:30option with a strike price of 15 which
34:33is what I did in straddle for $1 I'm
34:36looking to buy a put option with a
34:38strike price of 12.5 and now the price
34:41of that particular put option when the
34:43strike price is
34:4412.5 the price of that put option
34:49is25 okay the price of the call option
34:52with a strike price of 15 was how much
34:55two that's okay That Remains Two
34:58then price of every put call pair which
35:01I have is how much it is 2.25 two for
35:04the call option .25 for the put option
35:07if I buy 100 of those then what will I
35:10have what will be my total portfolio
35:12price it is
35:14225 that's my that's the amount I need
35:16to spend to buy a strangle
35:19portfolio Okay and which is which is
35:22significantly less than 300 which is the
35:25amount which I need to spend to buy a
35:28straddle
35:30portfolio
35:31also since 2.25 is the amount I'm
35:34spending on one particular unit of
35:37strangle that is one by a one put and
35:40one
35:41call I am hoping for a movement of
35:442.25 to break even only that much is
35:47good
35:48enough
35:52okay so it's it's a little cheaper than
35:54straddle that
35:56way great
35:59uh I think I will stop
36:02here and uh in the next lecture we'll
36:07talk about we'll look into a few more
36:09interesting uh uh financial instruments
36:13or or trading
36:15strategies and we will um also try to
36:21find out payoff of any particular
36:24portfolio any complicated portfolio
36:26which we might
36:28construct how to how to uh figure out
36:31the payoff of that we'll look at that in
36:34the next uh lecture we'll also look at a
36:39very important
36:40equality when it comes to pricing
36:46options but that we'll have to wait for
36:48that uh in the next lecture see you in
36:51the next lecture thank you

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