Portfolio insurance and portfolio protection involve a wide variety of strategies used to control investment risk in portfolios of various asset classes. By following these strategies, investment managers can mitigate the market risk without cutting off the ability of the portfolios to participate in the market upswings and add value.

In recent days, the most prominent financial news is that of the `global meltdown' and the crisis being faced by the financial sector world-wide. Ripples of this are being felt in stock exchanges all over the world. Indian investors too have been affected, with both the benchmark indices – NSE NIFTY and BSE SENSEX- falling steeply. This has resulted in a sense of gloom and the Government has tried to boost the sagging morale of the investors by injecting liquidity into the system. In fact, the Government of India has gone out of its way to reassure the market that India has not been affected much by the global crisis, and slowly but surely the market seems to be coming back to normal.

Anyone having an exposure to portfolio management will know that markets in the best of times behave unpredictably and the up and down movements of the curve are what make stock investments challenging and rewarding. However, portfolio managers generally like to make sure that falls are not steep enough to take them by surprise. To `insure' the portfolios against any such falls, managers enter into various deals. All such mechanisms undertaken to insure a portfolio come under a broad topic called `Portfolio Insurance.'

The concept of portfolio insurance first came into prominence after a research paper was published by Hayne Leland and Mark Rubenstein in the early 1980s. The basic philosophy of the scheme was that expected returns could be tailor-made to suit the risk profiles of the investors. Investors who hold assets could reduce the risk of their holding by: (1) diversification, (2) hedging or (3) insurance. Diversification involves finding other assets which have different `Betas' and forming a portfolio by combining the assets in such a way that the returns are optimized and the overall risk is reduced. Hedging involves entering into derivative transactions in such a way that the risk is negated, but, in the process, gains, which could accrue on movements in the opposite direction, are also negated. Portfolio insurance is basically a `best of both the worlds' solution, in which the portfolio is allowed to grow naturally, while protecting against downside movements.

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