QUESTION 2 (35 MARKS: 63 MINUTES) 910 11 12 13 14 15 16 17 18 Farha...

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QUESTION 2 (35 MARKS: 63 MINUTES) 910 11 12 13 14 15 16 17 18 Farha Tailor (FT) is one of the best tailors in Malaysia. It provides high end quality bespoke tailoring for men. In order to maintain the quality of its products, FT imports high quality textiles that include silk, wool and linen fabrics from the supplier in the United Kingdom (UK). Purchases are denominated in British pounds. FT normally would request its bank to convert ringgit to British pounds at prevailing spot exchange rate when making payments to the supplier in the UK. FT is expecting to make payment amounting 40,000 to the supplier in the UK in March 2024, three months from now. For the past few months, the value of Malaysian ringgit has been volatile against the British pounds. This has been due to uncertain economic condition in Malaysia. In view of the current situation, FT is considering to hedge the foreign currency payable. If FT decides to hedge the foreign currency payable, it has the option whether to use a forward hedge. an option hedge, or a money market hedge. Three-month put options on British pounds are available, with an exercise price of RM5.690 and a premium of RM0.03 per unit. Three-month call options on British pounds are available with an exercise price of RM5.700 and a premium of RM0.02 per unit. The spot exchange rate is RM5.741/. FT has managed to obtain the following information. Malaysia UK Three-month interest rate Inflation rate over the three- month period 2% 2.7% 1% 1.5% FT is concerned with the inflation rate in the UK as it is on the high side. The high inflation rate in the UK may have an effect on the cost of textiles imported from the supplier in the UK. The increase in the price of textiles would affect the cost of production and hence would reduce FT's profit. REQUIRED: (a) (b) (c) Determine whether forward hedge, option hedge or money market hedge is the most appropriate hedging strategy for FT to take to protect against the exchange rate risk. Assume interest rate parity and purchasing power parity exist between Malaysia and the UK. (20 Marks) Explain whether covered interest arbitrage exists between Malaysia and the UK, assuming the three-month forward rate is RM5.730/E (8 Marks) Explain how the British pounds spot and forward rates would adjust until arbitrage opportunity disappears soon after it has been discovered. Assume that covered interest arbitrage involving the immediate purchase and forward sale of British pounds is possible. (5 Marks) QUESTION 2 (35 MARKS: 63 MINUTES) 910 11 12 13 14 15 16 17 18 Farha Tailor (FT) is one of the best tailors in Malaysia. It provides high end quality bespoke tailoring for men. In order to maintain the quality of its products, FT imports high quality textiles that include silk, wool and linen fabrics from the supplier in the United Kingdom (UK). Purchases are denominated in British pounds. FT normally would request its bank to convert ringgit to British pounds at prevailing spot exchange rate when making payments to the supplier in the UK. FT is expecting to make payment amounting 40,000 to the supplier in the UK in March 2024, three months from now. For the past few months, the value of Malaysian ringgit has been volatile against the British pounds. This has been due to uncertain economic condition in Malaysia. In view of the current situation, FT is considering to hedge the foreign currency payable. If FT decides to hedge the foreign currency payable, it has the option whether to use a forward hedge. an option hedge, or a money market hedge. Three-month put options on British pounds are available, with an exercise price of RM5.690 and a premium of RM0.03 per unit. Three-month call options on British pounds are available with an exercise price of RM5.700 and a premium of RM0.02 per unit. The spot exchange rate is RM5.741/. FT has managed to obtain the following information. Malaysia UK Three-month interest rate Inflation rate over the three- month period 2% 2.7% 1% 1.5% FT is concerned with the inflation rate in the UK as it is on the high side. The high inflation rate in the UK may have an effect on the cost of textiles imported from the supplier in the UK. The increase in the price of textiles would affect the cost of production and hence would reduce FT's profit. REQUIRED: (a) (b) (c) Determine whether forward hedge, option hedge or money market hedge is the most appropriate hedging strategy for FT to take to protect against the exchange rate risk. Assume interest rate parity and purchasing power parity exist between Malaysia and the UK. (20 Marks) Explain whether covered interest arbitrage exists between Malaysia and the UK, assuming the three-month forward rate is RM5.730/E (8 Marks) Explain how the British pounds spot and forward rates would adjust until arbitrage opportunity disappears soon after it has been discovered. Assume that covered interest arbitrage involving the immediate purchase and forward sale of British pounds is possible. (5 Marks)