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Why go into structured products when you have a stock market that has quadrupled during the past three years? This is the question that has been asked of structured product developers in India on the back of the phenomenal bull run in the country's domestic stock index, the Bombay Stock Exchange Sensitive Index of 30 shares (Sensex).

Between May 2003 and May 2006 the Sensex climbed from 3,000 points to 12,000. But then market participants received a wake-up call after the index plunged by 826 points in one day – coinciding with the global market correction. Though the Sensex has recovered its value since then, the shockwaves felt in the market continue to linger and have led to a steady increase in the demand for structured products that offer capital protection. "We have seen equity market valuations reaching record highs in recent times," says Sai Tampi, head of portfolio management services at HSBC in Mumbai. "Following the correction in the markets earlier this year, many investors have become jittery and want increased capital protection. This is leading to greater opportunities for structured products developers."

Prior to May 2005, issuers had been prohibited from explicitly marketing capital-protected products to investors. In August, however, partly as a result of the stock market falls, the local securities regulator, the Securities and Exchange Board of India (SEBI), relaxed these rules, allowing issuers to offer funds with a rating agency seal of approval – effectively a synonym for a capital guarantee.

In the same month, Prudential ICICI (the asset management company created by a joint venture between the UK's Prudential Asset Management and India's second-largest bank, ICICI) introduced India's first capital-protected constant proportion portfolio insurance (CPPI) product, dubbed the Principal Protected Portfolio (PPP). Developed with Deutsche Bank in London, the product was one of the biggest innovations to hit the Indian market.

"Six months ago the average private banker wouldn't have heard of CPPI," Tampi says. "Since then a sea change has occurred and a flood of CPPI products has entered the market."

Prudential ICICI's CPPI has since been copied by a host of other issuers keen to tap the demand for principal protection. Typically, these products are issued within the portfolio management services (PMS) line offered by banks to their high-net-worth clients, although the growing appeal of capital protection has also seen the CPPI structure filtering into mass-market retail funds recently.

Apart from CPPI, however, innovation remains relatively thin on the ground in India. Structured product developers have been shackled by a strict regulatory regime that has thus far prevented the product advances seen in other Asian markets such as Hong Kong, Singapore and South Korea.

The use of over-the-counter derivatives by structured product issuers is currently prohibited in India. Structured product developers looking to use a listed alternative have in turn been constrained by the relatively short maturity of exchange-traded options, which only go out as far as three months. "If you want to do a five-year structured product using options it becomes very difficult because the rollover cost will kill you," says Arpit Agarwal, chief executive of financial advisory firm Dawnay Day AV.

Structured products momentum

But, as with so many aspects of this long-dormant giant, things are changing. With growing affluence among India's middle classes creating a more sophisticated and risk-hungry breed of investor, the demand for structured products is certainly on the increase. And structurers have been finding ever more innovative ways of creating new products to get around the regulatory restrictions.

For a start, another major development in the past few months has been the issuance of structured products in note format, created using 'synthetic' options. The first of these was issued by Standard Chartered in October and structured by Merrill Lynch, offering investors a cliquet option-based payoff.

"The synthetic options are hedged by dealers with international branches and issued in debenture format," says, Sandeep Das, business head of investment services and insurance at Standard Chartered in Mumbai. "They are perfectly legal structures, but the hedging of the payoff is done differently." The note gives investors between 70% and 75% upside exposure to the S&P CNX Nifty index, India's major large-cap equity index, while guaranteeing principal if the index falls by more than 60% over the three-year maturity of the note.

The knock-out optionality was hedged by Merrill Lynch through its overseas branches, hence getting round the domestic restrictions on derivatives use. To date Standard Chartered has issued around $15 million of these notes in the Indian market. And things are likely to progress even quicker next year.

Nikhil Kapadia, managing director of Deutsche Bank's Private Wealth Management service in Mumbai, believes that notes will outstrip funds by 75% to 25% as the dominant vehicle for structured product issuance in 2007. Standard Chartered's Das says that the bank is hoping to expand its business from the current $50 million of structured product notes to around $300 million next year.

Gold and property

A major factor likely to support growth in the market this year will be the introduction of structured products linked to more esoteric underlyings. Despite the meteoric performance of the domestic stock market in recent times, only about 10% of overall Indian investment actually goes into equities.

By far the biggest share is in gold and real estate – and it is these two areas that product developers are looking at. As long ago as May 2002, specialist exchange-traded fund (ETF) manager Benchmark Asset Management became the first fund manager in the world to file for permission to launch a gold ETF, although the lack of an adequate regulatory framework has meant that the ETF has yet to be launched.

However, regulations introduced this year that allow fund managers to warehouse gold mean that the ETF appears set for an imminent release, and may well spark a rush of copycat issues. Rajan Mehta, executive director at Benchmark, which currently monopolises the Indian ETF business and manages around $1.9 billion – 99% of the total ETF market – is optimistic. "India is the world's biggest importer and consumer of gold," he says. "It is one of the major assets among household investors. If we can issue products linked to the performance of gold it would give investors a huge boost."

The second area ripe for development is real estate. India's real estate market has surged during the past five years, but so far these investments have been accessible only through direct investment or long-only funds. However, several banks, including Standard Chartered, are looking to develop products which could provide investors with more tailored exposure to the asset class, in particular linked to venture capital real estate investment.

A final major development this year will be the move into overseas assets. Until recently, Indian investors have not been allowed to invest outside of India. But earlier this year the country's banking regulator, the Reserve Bank of India (RBI), relaxed its rules and allowed individual investors to put up to $50,000 into overseas securities, while domestic mutual funds now have a $3 billion ceiling for overseas investment. Product developers have been working on issuing CPPI structures linked to overseas assets, and participants predict there is a lot of traction to be had in this part of the business.

Despite a slow start, it seems that all the elements are coming together in the Indian structured products market. And with such a huge underlying investor base, India could well be on the cusp of a structured products boom. n

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