What is the parity price?
The parity price refers to a price level that fixes two assets or securities of equal value. It is a concept that is used in several markets, including fixed income, stocks, commodities and convertible bonds. For convertible bonds, the concept of parity price is used to determine when it is financially advantageous to convert a bond into common stock.
If two assets are trading at par, it can be inferred that they are at the same price or value.
Key points to remember
- The parity price describes a price level in two or more assets that represent equal or equivalent value.
- Depending on the type of asset it is used to value, parity prices can be used in a variety of different contexts.
- Parity is the price at which it becomes profitable for investors to convert their convertible bonds into common stocks.
- Parity can also be used to compare the value of two currencies.
Understanding the parity price
Investors often have to make decisions about the relative value of two different investments. Parity is a term used to describe when two things are equal. Thus, it can be used to refer to two securities with equal value, such as a convertible bond and the value of a share (if the holder chooses to convert a convertible bond into ordinary share).
In addition to using the parity price for a convertible security, investors can use it to make investment decisions on commodities and currencies. The parity price can help determine the value of stock options because parity is defined as the price at which an option trades at its intrinsic value. In addition, the concept of parity is also used to compare the value of two currencies.
Parity price: taking into account raw materials
For agricultural commodities, the parity price is the purchasing power of a particular commodity relative to a farmer’s expenses, such as wages, loan interest, and equipment. The Agricultural Adjustment Act of 1938 defines the parity price as the average price received by farmers for agricultural products over the previous 10 years; if the parity price of a product is lower than the current market price, the government can support prices through direct purchases.
Purchasing power parity
Purchasing Power Parity (PPP) is a method of comparing purchasing power between countries. PPP compares the cost of a basket of goods in one country with the cost of the same goods in another country. However, the purchasing power parity adjusts to the exchange rates between the two countries. In other words, the purchasing power parity adjusts two similar products should be the same price in both countries after calculating the exchange rates.
For example, let’s say an iPhone costs $ 600 in the United States. In Britain the exchange rate is $ 1.30 (it costs $ 1.30 for every pound sterling). So in Britain, if an iPhone costs around 460 pounds sterling, there would be purchasing power parity because 460 pounds equals $ 600 at the exchange rate of $ 1.30. However, if the UK iPhone costs more or less than 460 pounds, there would be no parity.
Parity in Forex markets
The parity is also found on the foreign exchange markets (forex). Currencies are at par when the exchange rate relationship is exactly one to one. US-based companies that do business in foreign countries must convert US dollars into other currencies. If an American company does business in France, for example, the company can convert US dollars into euros and send those euros to finance its business operations in France. If the exchange rate is $ 1 to € 1, the currencies are at par.
Parity price: how convertible bonds work
A convertible bond offers investors the option of converting said bond into a fixed number of ordinary shares at a specific price per share. Investors buy convertible bonds because the owner can earn interest on a fixed income investment (and they have the option of converting it into equity in the business). The parity price is the market price of the convertible security divided by the conversion ratio (the number of ordinary shares received upon conversion).
Other examples of parity
Suppose, for example, that an IBM convertible bond of $ 1,000 has a market price of $ 1,200 and the bond is convertible into 20 common shares of IBM. The parity price is: $ 1,200 bond market value) / (20 shares), or $ 60 per share. If the market price of IBM’s common stock is more than $ 60 per share, the investor can profit by converting them to common stock.
When an investor purchases a stock option, the owner has the right to buy a fixed number of shares at a specified price (and the right to buy the shares expires on a fixed date). A $ 50 call option from Microsoft, for example, means the owner can buy 100 Microsoft common stock at $ 50 per share before the option expires. If Microsoft’s market price is $ 60 per share, the intrinsic value of the option is ($ 60 – $ 50), or $ 10 per share. If the price of the stock option is also $ 10, the option trade is at-the-money.
Risk parity is an asset management process that assesses risk based on asset classes rather than capital allocation. The traditional asset allocation strategy divides assets between stocks, bonds and cash. The aim is to provide diversification and reduce risk by using these types of investments. Risk parity, on the other hand, divides dollars into four components: stocks, credit, interest rates and commodities.