The cost of downside protection and the time diversification issue in South Asian stock markets

Abstract

The objectives of this article are to carry out a comparative study of the costs of downside protection for investors in the stock markets of Bangladesh, India, Pakistan and Sri Lanka, and to investigate the time diversification issue in these markets by examining the variation of this cost as the investment horizon is extended. The cost of downside protection and time diversification effects are investigated by examining the properties of a protective put strategy and a capital protected equity participation strategy in each country's stock market over investment horizons ranging from 1 to20 years. Long-horizon investment outcomes are generated using a bootstrapping technique. Results indicate that the cost of downside protection differs from one country to another, but there is a common pattern of the cost decreasing as the investment horizon lengthens. In overall terms, the pattern of decreasing protection costs at longer investment horizons is consistent with the notion of the time diversification benefits of investment risk.

Acknowledgements

The valuable comments and suggestions made by Liang Zou are gratefully acknowledged.

Notes

¹ One-year growth rates in the Indian, Pakistani and Sri Lankan stock markets as at November 2005 were 24.6%, 54.3% and 64.6%, respectively.

² Datastream computes the country index from a constituent list of the larger stocks listed in the stock exchange representing at least 75–80% of the market capitalization in the country. The number of stocks in each index is 50 in the case of Pakistan and Sri Lanka and 100 in the case of India.

³ Weighted average share price is the price of the index constituent divided by the price of the index.

⁴ A description of the bootstrap re-sampling technique can be found in Efron (1979).