The recent events, such as US credit ratings issue, shrinking in cross-border capital flows between european banks reminds me my work at TuranAlem Securities.

At these times I have gathered and grew up team of very talented young boys and girls, which then formed core of my research team (both stock markets and industries). There we had very interesting disputes on practical application of fundamental principles, such as valuation of options or discount rate estimates (with no sufficient data available), portfolio construction and the like.

I don’t pretend I am super-duper guru in securities analysis and portfolio theories, but one idea we have elaborated eight years ago I believe now has all proves.

The efficient frontier idea is based on the fact that there should be only one portfolio with the most optimal risk – return balance. This portfolio is defined at the point where efficient frontier curve contacts with the tangent line, where tangent line is based on risk free (presumably US treasuries) rate.

We were working in former Soviet Union countries at those times and practice kept showing something is wrong with it. By some reason investors from emerging markets were way more risky than their colleagues in developed countries (working at the same markets).

Our idea was basically to modify some assumptions to explain this. The modifications were the following:

1. There are numerous barriers for capital flows, de facto.

This means not all investors have equal access to specific security (say, US treasuries). This access is often restricted or limited with local currency regulation, banks commissions (funds transfer) and other barriers.

This means local investors, if they feel they are isolated, they use their own “risk-free” rate, which in practice reflects opportunity costs for them. In my practice custom logic in minds of investors were rate of deposits in the largest domestic commercial banks. Risk free? Not at all. But provided that at these times some of the local banks in Russia, Ukraine or Kazakhstan had credit ratings equal to sovereign, this rate was really perceived as risk free in isolated financial ecosphere.

2. US Treasuries are not risk free.

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Of course what is going on right now clearly illustrates, how US debts are paid. Releasing more dollars obviously helps you to repay nominal values of the debts.  Obviously this escalates inflation and balloons other rates. So, if we have US Treasuries as the basis, still we might have rates escalated, because “risk free” securities are USD denominated.

Now, simple geometry. When you have risk free rate going up, tangent line moves the contact point to the right to more risky and potentially more profitable portfolios.

This, by the way, is applicable to the philosophy in the minds of local investors, which make direct / private equity / venture investments. Opportunity cost, objective barriers for capital flow and perception of what is true risk free rate is drive them to take more risks.

Again, I can not tell I am so sophisticated to challenge Mr. Markowitz and other gurus in investment management, it might look stupid and weird, but my on-the ground practice in post Soviet countries showed some very good illustrations. Now the whole financial world says theories should be modified.

Piece to all of you,  be strong in the next wave of crisis, and think of real values – our families and our nature.

Best,

Ruslan