INTEREST PARITY CONDITION & INDIAN PPREMIER LEAGUE

Here, I plan to study the effects of fluctuations in exchange rate market (current exchange rate) on balance sheets of various franchise owners competing in Indian Premier League 20-20. Fluctuations in exchange rates can have significant impact on financial positions of various teams as their major costs are denominated in US$, whereas the revenues are in terms of domestic currency (Indian Rupee).

Besides the effect of fluctuations of exchange rates on balance sheet, we also consider the implications of changes in expected exchange rate over a period of time i.e. between the inaugural and second edition of Indian Premier League. This reflects the investor sentiments regarding future prospects of an economy.

In this tournament, 8 teams from different parts of India compete for the coveted title. The top two teams also stand a chance to play in the Champions League 20-20, in which the top domestic teams of major cricket playing nations compete at a global level. Problems due to exchange rate fluctuations will also show up on the balance sheets of the teams in Champions League 20-20, i.e. pound-US$ exchange rate, Aus$-US$ exchange rate etc.

THE MODEL:

We assume that the money invested by the franchise owners in a team can alternatively be invested in Rupee denominated deposits in India, or dollar denominated deposits abroad. The minimum returns the potential owner would settle for should at least be equal to rate of return on rupee deposits, or rupee rate of return on dollar deposits. However, through interest parity condition, equilibrium in foreign exchange market would be attained when interest parity condition holds i.e. rate of return on rupee deposit equals rupee rate of return on dollar deposits.

R_Rs = R_$ + (X_Rs/$ - E_Rs/$)/E_Rs/$

R_Rs = Rate of return on rupee deposits (assumed to be constant)

R_$ = Rate of return on dollar deposits (assumed to be constant)

X_Rs/$ = Expected rupee-dollar exchange rate (assumed to be constant)

E_Rs/$ = Current rupee-dollar exchange rate (variable)

As per the model, say rate of return on rupee deposit is 8%, and dollar rate of return is 6% and expected depreciation of rupee against dollar is 4%. Then, according to the interest parity condition, rupee rate of return on dollar deposit is greater than rate of return on rupee deposit. So, everyone in the foreign exchange market would want to hold dollar against rupee; thus, rupee holders would have to offer more rupee per dollar and hence, rupee would depreciate and dollar would appreciate and moving toward equilibrium.

Similarly, say rate of return on rupee deposit is 10%, dollar rate of return is 6% and expected depreciation of rupee is 2%. The rate of return on rupee deposits is greater than rupee rate of return on dollar deposit, so everyone would want to hold rupee against dollar and dollar holders will have to offer more dollars per rupee for a transaction to take place. Hence, dollar depreciates and rupee appreciates and they move towards equilibrium.

NOTE: The only variable in our model is the current exchange rate and all other parameters in the equation are assumed to be constant.

EXPECTED RETURNS FROM THIS ‘VENTURE’

Majority of the potential owners have a demand base in India, thus the revenue is denominated in rupee terms. Also, the associate sponsors for the same reason deal in terms of rupee. However, as per the BCCI (Board for Cricket Control in India) guidelines, to cater to a unified global players market, a player is bought/sold in terms of US $.This accounts for about 45-62% of the total costs to owners. Figures are from 1^st edition of IPL where we had teams like Kolkata Knightriders who invested heavily in advertising & on other extreme team like Deccan Chargers who hardly spent anything besides the players market. Now let us bring in the fluctuations in the exchange rate market.

Now, the minimum rate of return for which an owner would settle for would at least be equal to the rate of return on rupee deposit which in turn would be equal to rupee rate of return on dollar deposits as per the interest parity condition. The rate of return beyond this would be the benefits realized from engaging in such a venture.

On the balance sheet front, during last IPL (May-June 2008) the rupee dollar exchange rate was 42.58 Rs/$ which at the current moment (March 2009) is 51.74 Rs/$. This represents a 21.5% depreciation of rupee against the dollar in the given time period. On the revenues side, the main sources are sponsorships, match tickets and merchandise which are all denominated in rupee. On the cost front, salaries of players (which constitutes about 65-72% of total cost) would be denominated in dollars which has appreciated by 21.5% against rupee over the period.(Assuming no role of derivatives in extension of dollar denominated fees). This figure simply shows a 1/5^th escalation in cost without engaging in any fresh transactions.

When rupee depreciates against dollar, then the purchasing power of rupee goes down. This is a double blow as the payments by the franchise owners have to be made in dollars, whereas all the receipts are in terms of rupees. As a consequence, the real profits of franchise owners go down. This shows that fluctuations in exchange rates can have adverse effects on the balance sheets of owners.

INTERPRETATIONS THROUGH INTEREST PARITY CONDITION

In the inaugural IPL, the final of which was played on 1^st June 2008, we can take the respective values of the characteristics which are:

• Rate of return on rupee deposit
• Rupee rate of return on dollar deposits
• Rupee-Dollar exchange rate as on 1^st June, 2008

With these figures, we can calculate the expected rupee-dollar exchange rate.

Now, the above parameters can be replaced with current figures and new expected rupee-dollar exchange rate can be calculated.

CASE 1

New expected rupee –dollar exchange rate > Last year’s rupee-dollar exchange rate

Say it increases from 45 Rs/$ to 50 Rs/$. This means that the investor sentiment has gone against the rupee and rupee has become less desirable over the period of time. This reflects that the future prospects of the economy & various ventures are not as good as they were in the previous year.

CASE 2

New expected rupee –dollar exchange rate <>

Say it goes down from 45 Rs/$ to 40 Rs/$. This means that rupee is now more preferred over dollar in that time period. This shows that the investors’ faith in rupee has increased with respect to the previous year.

Thus, changes in expectation of exchange rate reflects the investor sentiments which are very crucial for an economy.

NOTE: In this model, we have assumed that current exchange rates and expected exchange rates move independently, which is not the case in real world. The assumptions were simply taken to explain the fluctuation of exchange rates in a more appropriate and clear manner. In real world, as expectations will revise upwards, so will the prevailing exchange rates.