Parity Price

What Is Parity Price?

Parity price refers to a price level that sets two assets or securities equal in value to one another. It is a concept that is used in several markets, including fixed income, equities, commodities, and convertible bonds. For convertible bonds, the parity price concept is used to determine 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 they are at the same price or value.

Understanding 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 equivalent to one another. Thus, it can be used to refer to two securities having equal value, such as a convertible bond and the value of a stock (if the bondholder chooses to convert a convertible bond into common stock).

In addition to using parity price for a convertible security, investors can use it to make investment decisions about commodities and currencies. Parity price can help determine the value of stock options because parity is defined as the price at which an option is trading at its intrinsic value. In addition, the concept of parity is also used to compare the value of two currencies.

Parity Price: Factoring in Commodities

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 parity price as the average price received by farmers for agricultural commodities during the previous 10 years; if the parity price for a commodity is below the current market price, the government may provide price support through direct purchases.

Parity in Purchasing Power

Purchasing power parity (PPP) is a method of comparing the 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, purchasing power parity adjusts for the exchange rates between the two countries. In other words, purchasing power parity adjusts two similar products should be the same price in both countries after figuring for exchange rates.

For example, let's say an iPhone costs $600 in the U.S. In Great Britain, the exchange rate is $1.30 (it costs $1.30 for every British pound). So, in Britain, if an iPhone costs approximately 460 pounds sterling, there would be parity in purchasing power because 460 pounds equals $600 at the exchange rate of $1.30. However, if the British iPhone costs more or less than 460 pounds, there would not be parity.

Parity in the Forex Markets

Parity is also found in foreign exchange (forex) markets. Currencies are at parity when the exchange rate relationship is exactly one-to-one. Companies based in the United States that have operations in foreign countries must convert U.S. dollars into other currencies. If a U.S. firm does business in France, for example, the company can convert U.S. dollars into euros and send those euros to fund its French business operations. If the exchange rate is $1 to €1, the currencies are at parity.

Parity Price: How Convertible Bonds Work

A convertible bond offers investors the opportunity to convert said bond into a fixed number of shares of common stock at a specific price per share. Investors purchase convertible bonds because the owner can earn interest on a fixed-income investment (and they have the option of converting into the company’s equity). Parity price is the market price of the convertible security divided by the conversion ratio (the number of common stock shares received upon conversion).

Other Examples of Parity

Convertible Bonds

Assume, for example, that a $1,000 IBM convertible bond has a market price of $1,200, and the bond is convertible into 20 shares of IBM common stock. The parity price is: $1,200 bond market value) / (20 shares), or $60 per share. If the market price of IBM common stock is above $60 per share, the investor can profit by converting it into common stock.

Stock Options

When an investor purchases a stock option, the owner has the right to buy a fixed number of stock shares at a stated price (and the right to buy the shares expires on a fixed date). One $50 Microsoft call option, for example, means that the owner can buy 100 shares of Microsoft common stock at $50 per share before the option expires. If the market price of Microsoft 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 parity.

Risk Parity

Risk parity is an asset management process that evaluates risk based on asset classes rather than the allocation of capital. Tradition asset allocation strategy divides assets between stocks, bonds, and cash. The goal is to provide diversification and reduce risk by using these types of investments. Risk parity, on the other hand, allocates dollars based on four components: equities, credit, interest rates, and commodities.