The Securities and Exchange Board of India has shot down proposals from the mutual fund industry to float capital-guaranteed schemes, working on a mix of hedging and cash transactions.

The market regulator does not approve of mutual funds dabbling in derivatives to protect their cash positions. According to sources familiar with the development, Sebi has said capital-guaranteed schemes can be introduced only if a fund is backed by a sponsor or a financial institution, or a bank guarantee that it will step in to meet the shortfall if the fund's capital is eroded.

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Funds do not consider Sebi's idea "cost effective", and have put off plans to introduce such schemes at the moment. They wanted to invest in derivatives to assure investors that their capital would be protected against losses. Sources said the securities watchdog was not keen on derivatives being used for such a purpose.

Industry sources said mutual funds were disappointed with Sebi's reaction because capital-guaranteed schemes would have raised their inflow, especially into equity schemes.

The funds had proposed to invest a small portion of their investments in derivatives to lower risks associated with the cash market. Of Rs 100, if Rs 95 was invested in the cash market, Rs 5 would have been used to pay upfront premiums or margins on options and futures.

Therefore, the fund would have reaped an unlimited windfall if the market was buoyant, though the Rs 5 premium would have been wasted. But if the market was down, the fund could have exercised its hedging positions to recoup Rs 100.