Covered interest rate arbitrage with a two-tier exchange market (advanced).

Monsieur Dassault, the treasurer of Renault-Finance S.A.—the Geneva-based international finance subsidiary of the French automobile manufacturer—was intrigued by the apparently high yield offered by South African government bonds. Specifically, he could purchase rand-denominated ESCOM bonds (issued by the South African government-owned Electricity Supply Commission) at par that pay an 11 percent coupon in two equal half-yearly installments. The transaction would have to be channeled through South Africa’s two-tier exchange market: nonresident investors in South African bonds have to contend with a system of two different exchange rates that allows for investment (and divestment)

to be made through the financial tier, whereas interest payments are repatriated through the commercial tier. On July 19, 1989, the commercial rand was worth

$0.38 while the financial rand traded at $0.24. The central bank traditionally stabilizes the commercial rand while it allows the financial rand to fluctuate.

a. What is the effective rate of return on a rand (ZAR) 25 million uncovered investment, assuming that the investment is liquidated after one year?

b. Assuming a 6 percent discount on the financial rand, compute the effective yield on an uncovered investment of ZAR 25 million, assuming that the investment is liquidated after one year.

c. Discuss credit risk, exchange risk, interest rate risk, and country risk faced by nonresident investors in ESCOM bonds.

d. Compute the break-even exchange rate on the financial rand if Renault-

Finance is comparing its ESCOM investment with similarly risky dollardenominated high-yield bonds offering a coupon of 127∕8 percent. Sketch graphically your analysis.

(Adapted from “Of High-Yield Bondage,” The Economist, August 5, 1989, p. 65. )