Insurance operates on a simple basis: disasters are improbable. They strike only the unlucky few, and that too, at different times. It makes good sense, then, to have everyone contribute a small sum ('premium') to collectively compensate the unlucky few for the cruel twists of natural randomness. This is what insurers profit from.

However, if insurers see money in mitigating the losses of general randomness, shouldn't they also find profit in selling investors a safety net for stock market volatility?

The straight answer is no. Insurance needs to keep premia collections above payout expectations, with the latter calculated from disaster probabilities that must remain theoretically stable across large populations. The trouble is that stock market movements are way too quick, way too volatile and way too bewildering for actuarial analysis to do any good. Moreover, there's the problem of systemic risks, which affect the entire market simultaneously. Some of these are not just excruciatingly complex, they're man-made. While the super-rational might try quantifying these, it would be a brave insurer who covers them.

So, should investors just sigh and get back to work? Not at all. The straight answer is not the only answer there is.

Spreading Risk

Insurance, at its core, is a mechanism that reallocates risk in a manner that minimises unbearable losses to those who opt for it. Now, well-evolved financial markets also have mechanisms designed to achieve the same effect. Indeed, these are the very tools that financial whizkids use when they talk of 'hedging' their portfolios against volatility. The disheartening part is how few investors ever opt for these.

The fact is, anybody can buy himself a simple form of portfolio insurance by adopting an investment strategy that uses these safety tools. Take options, for instance, which literally assure their holder the right to 'opt' for a certain action ('buy' or 'sell') in the future, under some conditions. "Assume that an investor has bought a stock with the expectation that it will go up, but doesn't want to take the risk of it going down. The best way out is to buy a put option with it," elaborates Errol D'Souza, Senior Vice President, DSP Merril Lynch. A put option, which costs a little sum ('premium'), is the right to sell the particular stock at a prefixed price (the 'strike price') to the option-issuer within a prefixed time frame. If it crashes, the put option can be exercised to escape unhurt.

Options are particularly useful when it comes to a runaway market. For example, an investor expecting a prolonged market slide (before an upturn) might sell some of his holding in a stock, hoping to buy it back cheaper some time later. This is a smart strategy, but a sudden price rise can throw the plan into disarray. The safety device is a call option, assurinsg him the right to buy the stock, regardless of market movements, at a pre-decided low price.

Options sound wonderful, don't they? Then how come investors are not rushing to insure their investments?

Premium Pains

Options, some investors groan, are available only for a handful of blue chips. And even with a blue chip portfolio, buying assorted options for individual scrips is rather too expensive. The solution for such investors is the index option, which offers a call or put on a composite bunch of stocks representing the entire index. Such options serve as proxies that make good losses incurred on a well diversified portfolio, the ups and downs of which are likely to mirror the index. This works especially well for a diversified portfolio of stocks with 'beta' values (which measures the co-volatility of a stock with the index) close to 1.

So actual availability of options is not much of an issue. The real 'put off', so to speak, is the prices at which they are selling. Is there a cheaper way out for investors? Yes, says Jitendra Panda, Vice President (Retail Broking), Motilal Oswal Securities. Buy 'out of money' put options, he advises. These are put options with the strike price below the current market price. A loss-cutting deal. In other words, the investor is willing to take a hit-so long as it is not a devastating hit, and needs to pay accordingly lower for the option of merely cutting his losses. It's simple: less protection for less money.

That, however, still doesn't solve the basic problem: of generally high option prices. The derivatives market in India is still nascent, and it operates as any market does-with prices determined by the interaction of demand and supply. The trouble is, options need to gain volumes before the risks are spread so widely as to be offered cheaply. Like insurers, option sellers also need to achieve some measure of stability in their payout expectations, and that requires a market that's bustling with option deals. Sadly, this is not the case. Longer duration three-month options, in particular, have rather few takers.

Other than that, option pricing depends on such factors as volatility (higher volatility spells a higher premium). Yo-yo stocks command higher premia than relatively stable stocks. The other determinant is time value. A two-month option costs more than a one-month option.

Other Confusion

Volumes must grow. But it doesn't help that investors are confused about the taxation on profits or losses arising out of options trading. Business income or capital gains? The former, if the activity is regular, says Bhavesh Vora, Chartered Accountant. The latter, if the investor can prove the tools' use as a hedge mechanism for particular assets, says Gautam Nayak, Tax Consultant. And what about index options? "Once the special law for derivatives is in place," says a hopeful Vora, "things should be more clear." Good. The volatility-striken are waiting.

FII Effect...
The market's up... yippee, and thanks all ye FIIs. Or so goes the conventional wisdom. But are FIIs really so potent a force?

Everyone knows why the Sensex is sizzling. An 'F' followed by two 'I's. Foreign institutional investors-to the thoroughly uninitiated. Following the fii bucks, thus, comes naturally to analysts. Inflow, outflow. By the day, by the session, by the hour.

It's exciting. But count us out.

Not to suggest that FII money is irrelevant; it would be absurd to claim so (money is money and FIIs have lots). But to put the fii-elevated-Sensex hypothesis to the test of actual market experience.

No doubt, FII inflows this year have been hot. Historically, however, the Sensex link has been tenuous. The 1999 bull run, for example, didn't see too much FII participation, while 2001 saw a Sensex slide (and a pre-9/11 slide too) despite heavy FII inflows. Last year was a washout on both counts, admittedly. But is this year's bull market really an FII creation? On several individual stocks, March-to-June records show rising price graphs in spite of declining FII stakes. Sure, one may argue that the FII frenzy began only later, so we need to look at later data. But still, rising prices are rising prices. There's evidence that the BSE rally started way back in April, and these factors must still be in play.

How does it all add up? Hear out Dileep Madgavkar, CIO, Prudential ICICI mf: "No one factor can drive the market." Agrees Sanjay Sachdev, CEO and MD, Principal mf, "FII inflow is only one part, and only brokers are looking at these."

Adds Ajay Bhatia, head of research, Enam Securities, "Money flow can come from within India, which is under-owned in equities." There is plain good reason to buy stocks, based on valuations, and that cuts across the investor spectrum in India. Besides, as returns on debt and bank deposits fall, even the conservative salaried individual is looking to equities. And he's discovering good picks. "While extreme undervaluation doesn't exist anymore," elaborates R. Sukumar, CIO, Templeton MF, "The markets are clearly not overvalued if one looks the return on equity (RoE) of corporate India and the potential for economic growth going ahead."

So, has retail interest been re-ignited? Not entirely. For most people, even one bad experience in the past is one too many. Yet, temptations grow. A retail investment wave would make it abundantly clear that the FIIs are not the sole force behind the Sensex's rise-even if the FIIs wield awesome direction-setting power. But then again, even on this-the signaling effect-there are other locally-rooted claimants to the role.

-Narendra Nathan