FTSE World Parity Unit (FTSE WPU)

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1 Methodology overview FTSE World Parity Unit (FTSE WPU) Introduction Key features For nondomestic funds, currency risk can be the largest single risk faced by the fund. Global equities have highly undiversified foreign currency risk. Historically investors have accepted currency exposure as the unplanned consequence of international asset allocation decisions. The implicit currency risk of a global equity basket is concentrated in four currencies (USD, Euro, Sterling and Yen) with unsustainable deficits and the incentive to monetize this debt. The FTSE World Parity Unit (FTSE WPU): FTSE WPU s basket of currencies and commodities exhibits greater stability than any single currency, thereby stabilizing currency allocations. Investors may wish to use FTSE WPU to mitigate the risk arising from exchange rate fluctuations and the erosion of purchasing power by inflation. FTSE WPU is not designed to provide an expected return: the role of FTSE WPU is to act as a stable global currency unit for global investors. The base date of the FTSE WPU is December 31, The base value of the FTSE WPU is one, such that as of the base date the WPU:USD exchange rate is one. The FTSE WPU is a spot reference rate. is a unit comprising a basket of currencies and commodities; represents an exchange rate based on market sources between the basket of currencies/commodities falling within WPU and the US Dollar; is a mechanism which organizations may wish to use in order to control investment risks and diversify currency risks at lower cost; and is maintained with clear, transparent and freely available rules. Institutions wishing to use WPU will need to understand the rules carefully and assess for themselves whether WPU is right for use with their products or for their clients. FTSE does not provide an investment advisory service and nothing in this communication presents investment advice. Cumulative Growth FTSE WPU through time 6 WPU appreciation against USD 4 World Inflation 2-2 USD depreciation against Euro -4 USD depreciation against Gold EUR depreciation against Oil USD : EUR WPU : USD ftserussell.com USD : Ozs of Gold World Inflation EUR : Barrels of Oil 1

2 Developed currency component: Diversifying foreign currency exposure Global wealth and the majority of international transactions, both trade and financial, are concentrated in the capital markets of the US, Europe, Japan and the UK. Consequently wealth tends to be held in the currencies of these countries. Developed market currency component weights in FTSE WPU are determined under its rules by a constrained optimization that minimizes the variance of a basket of foreign currencies relative to the USD and ensures a more diversified set of currency holdings. Cumulative USD: WPU and Euro: WPU Return Euro more recent depreciation against WPU USD depreciating against WPU USD : WPU Euro : WPU WPU:Australian Dollar and USD: Australian Dollar Rates AUD depreciating AUD appreciating USD : AUD Emerging currency component: Hedging external devaluation risk WPU : AUD Developing economies represent an increasing component of world GDP and are significant producers of goods and services. The FTSE WPU rules allow for maintaining the purchasing power of developed market currencies relative to developing market currencies, as the latter s currencies appreciate in value relative to developed market currencies. FTSE WPU assumes a position in each developing market currency that is proportionate to each nation s contribution to world GDP. Consequently, as developing economies form a larger part of the world economy, FTSE WPU will automatically reflect the increasing importance of maintaining the ability to purchase goods and services from the developing world. Developing market currencies are proxied by the BRIC country foreign exchange rates relative to the US dollar, which is itself a proxy for the developed world. WPU:Brazilian Real and USD: Brazilian Real Rates BRL depreciation USD : BRL WPU : BRL BRL appreciation 2011 Currency risk The paper currency risk to a Global Investor is large and has a negative real return. Currency swings also dominate investment returns. Developed market investors are increasingly aware of the need to preserve value in global terms or hedge home currency risk Investors outside of the main currencies are acutely aware of home currency risk, but face undiversified domestic currency risk and unhedged cashflow risk if they fully hedge Currency risk will restrict attempts to diversify outside of one s home market. This is a particular problem in countries where funds are large relative to the domestic asset market. These funds are forced to invest outside their home market and incur the currency risk. Methodology overview 2

3 Commodity component Hedging internal devaluation/ inflation risk Over time unexpected inflation destroys real wealth. Therefore in order to maintain purchasing power, periods of negative real return should be minimized. The link between commodity prices and inflation may be captured by the energy and precious metal sectors of the commodity markets. Historically, storable commodities have exhibited a positive and statistically significant relationship to changes in the global inflation rate.thus oil, gold and silver can serve as an effective hedge against a decline in the real value of money. The high historic volatility of silver, particularly on the downside, results in a low FTSE WPU weighting to silver. The minimum FTSE WPU component weight is 25bp, consequently the weight allocated to silver is zero. Commodity prices also represent the exchange rate between commodities and the value of the US dollar. Historically, commodity prices were set and priced in US dollars, but increasing global demand for commodities means that they are increasingly being set by global supply and demand conditions. The consequence is a negative correlation between the US price of commodities and the external value of the US dollar i.e. if the US dollar falls against foreign currencies, commodity prices rise in US dollar terms. Hence, commodity exposure may also offer global investors an additional hedge against a loss in the relative purchasing power of developed market currencies. FTSE WPU component weightings as of November 2011 Developed Country Weights 82% Gold, 3.06% CNY, 7.17% Commodities Silver, 0.0 Developing Oil, 1.51% BRL, 2.55% RUB, 1.8 INR, 2.11% Commodity Weights 4% Developing Country Weights 14% USD, 23.13% CAD, 5.15% CHF, 6.21% Developed EUR, 10.04% AUD, 6.89% 12.57% GBP, JPY, 17.81% Methodology overview 3

4 Hedging into FTSE WPU Global investors preference for assets in the leading developed market countries is a function of the size, liquidity and transparency of those markets. Global investors may wish to use the FTSE WPU to mitigate the risk of external loss from changes in relative valuation in currencies through exchange rate fluctuations and internal loss from an erosion of purchasing power by inflation. Hedging into FTSE WPU could reduce a fund s currency risk. Home country currency appreciation can lead to material currency losses for a fund that may outweigh the performance impact of all other active decisions a fund makes as part of the investment process. FTSE WPU offers the scope to hedge large currency exposures. For certain currencies, the foreign exchange market lacks sufficient depth for a fund to be able to hedge back to its domestic currency. The lack of depth and the risk of extreme currency movements places limits on international exposure. Foreign currency risk is a dominant source of the home currency bias exhibited by funds in most countries. FTSE WPU offers an alternative to hedging the currency exposure of international investments into a fund s home currency. FTSE WPU Component Weights Developing/Commodity 16% 14% 12% 1 8% 6% 4% 2% Developing Commodity Developed FTSE WPU Commodity Component Weights 4% 3% 2% 1% Oil Gold Silver FTSE WPU Developing Component Weights 8% 7% 6% 5% 4% 3% 2% 1% BRL RUB INR CNY 94% 92% 9 88% 86% 84% 82% 8 78% 76% Developed FTSE WPU Developed Component Weights 35% 3 25% 2 15% 1 5% EUR JPY GBP AUD CHF CAD USD Methodology overview 4

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