WaterQuay Engineering Ltd (WQEL) is a big player in the yacht industry in the United Kingdom (UK). WQEL customers in the UK, account for a third its revenue, the rest are based in Europe. WQEL has the expertise locally to construct its yachts, but sources all the required components and materials from Germany. Following UK's withdrawal from the European Union (EU), the UK government has increased taxes imports. WQEL's main competitors who are based in France and Germany. There are no import tariffs between France and Germany due to the EU trade agreements. Local governments have also increased berthing costs by 20% on all mariners and harbours in the South. Over the last three months, the EURO/GBP (/) rate has ranged from 0.8566 - 0.9230, the previous 52 weeks range was 0.8603 - 0.9429. The UK economy has been deeply affected by the COVID-19 pandemic in the last year. As we go to the press the markets seem to be reacting positively to the UK's COVID-19 vaccination programme and government stimulus. The Finance Director is concerned about the impact that economic risk will have on the business. WQEL expects to make a payment of 7,500,000 to its main supplier in six months' time. The following market information is available: Spot Euro/GBP is 0.8630 - 0.8649 6-month Euro interest rate is 7 - 9% per annum 6-month GBP interest rate is 5 - 8% per annum European call Options Euro/GBP Strike price is 0.8685 Option fee 0.01/Euro Euro/GBP Forward contract in September is 0.8734 - 0.8753 3

Required: 

a) Describe what you understand by the term, 'economic risk' and explain how it is distinguished from 'transaction risk'

b) Given your answer in (a) discuss the impact that economic and transaction risk could have on WQEL's business.  

 

c) Explain using relevant calculations how this risk may be managed given the market information above. Give a critical opinion on the best course of action. 

 

d) The Finance Director wants to explore one more alternative and is considering the futures market. The following information is available: September Euro/GBP Futures is 0.8685 Contract 125,000 Assume that the spot rate and the futures market rate for / are the same in September and that there is no basis risk. Calculate the effective cost to WQEL if the rate in September is: i) 0.8600 ii) 0.8900 iii) Comment on your results and what WQEL should be aware of.