What Is Parity Price?
Parity price refers to a price level that makes two assets or securities equal in value. This concept is used across various markets, such as fixed income, equities, commodities, and convertible bonds. For convertible bonds, parity price determines when it’s financially advantageous to convert a bond into shares of common stock.
If two assets are trading at parity, they are of the same price or value.
Key Takeaways
- Parity price represents equal or equivalent value between two or more assets.
- Depending on the asset type, these prices can be contextualized differently.
- In convertible bonds, it’s the point at which investors benefit from converting bonds to stocks.
- Parity can also compare the value of two different currencies.
Understanding Parity Price
Investors often assess the relative value of different investments. Parity is a term indicating when two values are equivalent, used widely in things like convertible bonds and stock values from those bonds converging into common stock shares.
Beyond convertible securities, parity price is instrumental in commodity and currency investments too. In stock options, it’s the price at which an option trades at intrinsic value. It also helps compare two currencies’ values.
Purchasing Power Parity (PPP)
PPP is a technique comparing the purchasing power between countries by examining the cost of a basket of goods in each. PPP adjusts for exchange rates to assess equal purchasing costs of similar goods in respective countries.
Factoring in Commodities
In agricultural commodities, parity price relates to the purchasing power of farmers in light of their expenses, such as wages and equipment costs.
The Agricultural Adjustment Act of 1938 defines it as the average price received by farmers over the previous ten years. If the parity price falls below market price, the government offers price supports.
Parity in the Forex Markets
Parity also exists in forex markets, where the exchange rate between two currencies is strictly one-to-one. For example, a U.S. company converting dollars to euros at a $1 to €1 rate reflects currency parity.
On July 12, 2022, the euro reached parity with the U.S. dollar for the first time in 20 years as the euro’s value dropped significantly against the dollar.
Interest Rate Parity
Interest rate parity (IRP) deals with the relationship between interest rates and currency exchange rates, positing that the returns from investments in different currencies should equal when covered. It forms the basis for identifying forex arbitrage opportunities.
The IRP can be calculated as:
- F0=Forward Rate
- S0=Spot Rate
- i_c=interest rate in country ‘c’
- i_b=interest rate in country ‘b’
Parity Price: How Convertible Bonds Work
The conversion parity price of a convertible security represents the break-even point for converting said bond to common stock. Convertible bonds allow investors an opportunity for fixed income before possibly converting to equity.
It is calculated as follows:
Conversion Parity Price = Market Price of Convertible Security / Conversion Ratio
Example
Consider a $1,000 IBM convertible bond with a market price of $1,200, convertible into 20 shares of stock:
Parity Price = $1,200 / 20 shares = $60 per share
If IBM common stock trades above $60 per share, converting to common stock is profitable.
Parity in Options Trading
In options trading, parity ensures the price of an option is in line with its intrinsic value. Suppose a $50 Microsoft call option enables buying 100 shares at $50 each; if Microsoft’s market price is $60, the option’s intrinsic value is $10 per share. If an option is also priced at $10, it’s at parity.
Options trading utilizes put-call parity to reflect fair option pricing for identical assets. The formula for put-call parity is:
C + PV(x) = P + S
where:
- C = Call Price
- PV(x) = Present Value of Strike Price
- P = Put Price
- S = Current Market Price
What Is Risk Parity?
Risk parity addresses asset management by evaluating risk by asset classes—equities, credit, interest rates, and commodities—promoting diversification and risk mitigation beyond traditional capital allocation.
Covered vs. Uncovered Interest Rate Parity
Covered interest rate parity (CIP) pertains to no-arbitrage via forwards to hedge FX risk. Uncovered interest rate parity (UIP) theorizes equality in international rates absent forwards.
What Is Percent of Parity?
Percent of parity measures the gap between two prices or rates compared to achieving absolute parity. If the parity percentage between two entities is 90%, they are 10% away from full parity.
The Bottom Line
Parity signifies equality or equivalence across various financial contexts, whether in forex, options trading, or convertible securities. It’s crucial for understanding market conditions, identifying deviations, and spotting trading opportunities within the concept of equality.
Related Terms: intrinsic value, conversion parity price, interest rate parity, risk parity, covered interest rate parity, put-call parity.
