Farha Tailor$($FT$)$is one of the best tailors in Malaysia. It provides high end quality bespoke

tailoning 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 supplet 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 markel hedge. Three$-$month put options on British pounds are

available, with an exercise price of RM$5\mathrm{.}690$and a premium of RM$0\mathrm{.}03$per unit. Three$-$month call

options on British pounds are avalable with an exercise price of RM$5\mathrm{.}700$and a premium of

RM$0\mathrm{.}02$per unit. The spot exchange rate is RM$5\mathrm{.}741/.$

FT has managed to obtain the following information.

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 FTs

profit.

REQUIRED:

$($a$)$Determine whether forward hedge, option hedge or money markel 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 Malaysla and the UK$.$

$(20$Marks$)$

$($b$)$Explain whether covered interest arbitrage exists between Malaysia and the UK$,$

assuming the three$-$month forward rate is RM$5\mathrm{.}730/$E$.$

$(8$Marks$)$

$\text{'}$c$)$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$)$