Safety net is but a put option

B. Venkatesh

KARVY Investor Services Limited (KISL) is offering a ``safety net'' to investors.

This means investors who subscribe to the initial public offer (IPO) of a company specified by KISL can sell those shares to KISL at the initial offer price. KISL has kicked off the ``safety net'' with the IPO of Opto Circuits.

Now, what is this safety net? It is actually a put option given to the investors, not by the company issuing the shares but by KISL. A put option gives the right but not the obligation to the investors to sell the stock to KISL at a particular price before a certain period.

The subscribers to Opto Circuits' IPO can sell the shares to KISL before May 3, 2001 at a price of Rs 50 per share. The investors, thus, have a put option with a strike price of Rs 50 per share with an expiry of six months. As KISL gives the investors the right to sell the shares at any time before the expiry of six months, the put is an American option.

Such an option makes the instrument attractive to investors. How? Suppose the stock falls to Rs 25 three months hence, an investor would lose Rs 25 (Rs 50-25) per share on his investment. A put option, however, enables the investor to sell the stock to KISL at the strike price of Rs 50 per share.

Next, suppose the stock moves up to Rs 60, the investor can sell it in the market and pocket the gains. He is under no compulsion to sell the share to KISL which is why the safety net is an option.

But there is a difference between the safety net and an option. An option requires you to pay an upfront premium to the option writer. This premium is compensation to the writer for the risk of having to buy the stock from you at a higher-than-market-price. KISL's safety net does not require you to pay such a premium which makes it more attractive. KISL perhaps plans to pep the IPO market by writing put options. Will it be successful?