The Securities and Exchange Board of India is planning to allow mutual funds to launch capital-guaranteed schemes, which will assure investors that their principal at least is always protected.

The schemes will ensure that the original investment of the investors is not lost or that the losses are limited to a certain extent.

Since this will involve the use of derivatives, the Association of Mutual Funds of India is working to devise a product for the market regulator's clearance.

Simply put, the scheme essentially works on these lines: suppose an investor invests Rs 100. Of this, Rs 95 is invested in equity.

The remaining Rs 5 acts as the margin money as the fund buys an option to sell the securities at Rs 100. If the Rs 95 investment goes up beyond Rs 100, the fund has the choice not to exercise the option.

But if the market value of that investment does not measure up to Rs 100 -- thus, carrying with it the chance of capital erosion -- the fund can exercise the option.

Industry sources said that while theoretically it worked very well, 'in practice, there is no perfect hedge.'

So generally the sponsor of the fund or the asset management company will ultimately will have to provide the assurance for the capital guarantee.

Overseas, capital guarantee products are quite the rage since the investor has the satisfaction of knowing that at least his original investment is protected, even if an appreciation is subject to market forces. Typically such schemes are close-ended and have a lock-in of between 3 and 5 years.

Another way of guaranteeing the capital investment is by investing Rs 90 in bonds for three years and the remaining Rs 10 aggressively in equity or to put Rs 97 in zero coupon government securities or triple-A rated bonds.

Industry circles said the time is ripe for such schemes but they will have to have the right safeguards as all guaranteed schemes carry with them the risk of defaults since funds make not always make the right calls in the market.