What Is Parity Price?
Parity price refers to a price level that sets two assets or securities equal in value to one another. This concept plays an essential role in various markets including fixed income, equities, commodities, and convertible bonds. For convertible bonds, the parity price indicates when it is financially beneficial to convert a bond into shares of common stock.
If two assets are trading at parity, it can be inferred that they are at the same price or value.
Key Takeaways
- Parity price describes a price level in two or more assets that represent equal or equivalent value.
- It can be relevant in a variety of contexts depending on the type of asset being priced.
- In convertible bonds, parity is the price at which it becomes profitable for investors to convert their bonds into shares of common stock.
- Parity can also be used to compare the value of two currencies.
Understanding Parity Price
Investors often need to evaluate the relative value of different investments. Parity signifies when two things are equivalent to one another. It commonly applies to two securities having equal value, like a convertible bond and the value of a stock if the bondholder opts to convert the bond into common stock.
Applying Parity Beyond Convertible Securities
In addition to convertible bonds, investors can use parity prices for commodities and currencies. The parity price helps determine the value of stock options, as this price is defined by the option trading at its intrinsic value. Moreover, the term is vital for comparing the value of two currencies.
Purchasing Power Parity (PPP)
Purchasing power parity (PPP) is a method of comparing the purchasing power between countries. This approach compares the cost of a basket of goods in one country with the cost of the same goods in another, adjusting for exchange rates to ensure that equivalent products should have the same price in both countries.
Factoring in Commodities
For agricultural commodities, the parity price signifies the purchasing power of a commodity relative to a farmer’s expenses like wages, loan interest, and equipment.
The Agricultural Adjustment Act of 1938 defines parity price as the average price received by farmers for agricultural commodities over the previous 10 years. If the parity price for a commodity is below the current market price, the government may support prices through direct purchases.
Parity in the Forex Markets
In foreign exchange markets, parity is observed when the exchange rate between two currencies is precisely one-to-one. Companies operating internationally, like the U.S. firms in Europe, must periodically convert U.S. dollars into euros for local operations. On July 12, 2022, the euro reached parity with the U.S. dollar for the first time in 20 years, symbolizing a major currency fluctuation.
Interest Rate Parity
Interest rate parity (IRP) is a critical equation that explains the relationship between interest rates and currency exchange rates. The principle suggests that returns on investments in different currencies should be identical when hedged.
The formula for IRP is:
- F0 = Forward Rate
- S0 = Spot Rate
- ic = Interest rate in country c
- ib = Interest rate in country b
Parity Price: How Convertible Bonds Work
The conversion parity price in a convertible security shows the break-even price. Convertible bonds let investors convert bonds into shares of common stock at a specific price. Parity price is calculated as follows:
Conversion Parity Price = Value of Convertible Security / Conversion Ratio
Example:
Assume a $1,000 convertible bond of IBM is priced at $1,200 and can be converted into 20 shares of IBM common stock. The parity price is:
Parity in Options Trading
In the context of stock options, parity means the option pricing matches its intrinsic value. For instance, a $50 Microsoft call option allows buying 100 shares at $50 each before expiration. If these shares are valued at $60 each in the market, the option’s intrinsic value is $10. Trading at this level means the option is at parity.
Put-call parity also defines the balance between put and call options of similar underlying assets, expiration dates, and strike prices. The formula is:
$$C + PV(x) = P + S$$
where:
- C = Call price
- PV(x) = Present value of the strike price, x
- P = Put price
- S = Current market price of the underlying security
What Is Risk Parity?
Risk parity is an asset management strategy that allocates dollars based on asset classes (equities, credit, interest rates, and commodities) rather than traditional capital allocation. It aims to reduce risk and offer diversification.
What Is Covered vs. Uncovered Interest Rate Parity?
Covered interest rate parity involves no-arbitrage conditions achieved through forward contracts to hedge against forex risk. Uncovered interest rate parity, on the other hand, doesn’t consider forward rates and highlights interest rate and exchange rate correlations.
What Is Percent of Parity?
Percent of parity describes how much difference from complete parity exists between two prices or rates. A value of 100% signifies parity, while, e.g., a 90% suggests a 10% gap from parity.
The Bottom Line
Parity signifies equality, derived from Latin paritas. In finance, parity price reflects a variety of scenarios where the concept of equivalent value applies. This aids in understanding deviations, creating pathways for arbitrage and supporting trading strategies.
Related Terms: Convertible Bonds, Intrinsic Value, Purchasing Power Parity, Interest Rate Parity, Risk Parity.
