Table of Contents
- What Is Parity Price?
- Understanding Parity Price
- Purchasing Power Parity (PPP)
- Factoring in Commodities
- Parity in the Forex Markets
- Interest Rate Parity
- Parity Price: How Convertible Bonds Work
- Parity in Options Trading
- What Is Risk Parity?
- What Is Covered vs. Uncovered Interest Rate Parity?
- What Is Percent of Parity?
- The Bottom Line
What Is Parity Price?
Let me explain parity price to you directly: it's a price level that makes two assets or securities equal in value. You'll see this concept in markets like fixed income, equities, commodities, and convertible bonds. For convertible bonds, parity price helps determine when it's financially smart to convert the bond into common stock shares.
When two assets trade at parity, they're at the same price or value—simple as that.
Understanding Parity Price
As an investor, you often decide on the relative value of different investments. Parity describes when two things are equivalent. It applies to securities of equal value, like a convertible bond and the stock value if you convert it.
Beyond convertibles, use parity for commodities and currencies. It determines stock option values by showing when an option trades at its intrinsic value. Parity also compares currency values.
Purchasing Power Parity (PPP)
Purchasing power parity compares purchasing power between countries. It looks at the cost of a basket of goods in one country versus another, adjusting for exchange rates. Essentially, similar products should cost the same in both after exchange rate adjustments.
Factoring in Commodities
For agricultural commodities, parity price measures a commodity's purchasing power against a farmer's expenses like wages, loan interest, and equipment.
The Agricultural Adjustment Act of 1938 sets parity as the average price farmers received over the previous 10 years; if below market price, the government might support through purchases.
Parity in the Forex Markets
In forex, parity means a one-to-one exchange rate between currencies.
U.S. companies operating abroad convert dollars to other currencies. For example, converting to euros for French operations at $1 to €1 means parity.
Note this: On July 12, 2022, the euro hit parity with the U.S. dollar for the first time in 20 years, falling to its lowest since 2002.
Interest Rate Parity
Interest rate parity is the equation linking interest rates and currency exchange rates. Its premise: hedged returns from different currencies should match, regardless of rates. If rates rise in one country, exchange rates adjust accordingly. Forex traders use it for arbitrage.
The formula is F0 = S0 × (1 + ic) / (1 + ib), where F0 is forward rate, S0 is spot rate, ic and ib are interest rates in countries c and b.
Parity Price: How Convertible Bonds Work
Conversion parity price is the break-even on a convertible security.
Convertible bonds let you convert to a fixed number of common stock shares at a set price. You buy them for interest plus conversion option. Parity price is market price divided by conversion ratio.
Example: A $1,000 IBM bond at $1,200, convertible to 20 shares, gives parity of $1,200 / 20 = $60 per share. If stock exceeds $60, convert for profit.
Parity in Options Trading
A stock option lets you buy shares at a stated price before expiration. For a $50 Microsoft call on 100 shares, if market is $60, intrinsic value is $10. If option costs $10, it's at parity.
Put-call parity relates put and call options with same asset, expiration, and strike: C + PV(x) = P + S, where C is call price, PV(x) is present value of strike, P is put price, S is market price.
What Is Risk Parity?
Risk parity manages assets by evaluating risk across classes, not capital allocation. Traditional strategies use stocks, bonds, cash for diversification. Risk parity allocates based on equities, credit, interest rates, commodities.
What Is Covered vs. Uncovered Interest Rate Parity?
Covered interest rate parity uses forward contracts to hedge forex risk for no-arbitrage. Uncovered is the theoretical link between rates and exchanges without forwards.
What Is Percent of Parity?
Percent of parity shows the difference from full parity (100%). If 90% between two items, it's 10 points from parity.
The Bottom Line
Parity means equality, from Latin 'paritas.' In finance, it refers to equivalence in contexts like forex 1:1 exchanges, put-call in options, or convertible bond conversions. It helps spot deviations for arbitrage opportunities.
Key Takeaways
- Parity price sets equal value in two or more assets.
- It applies in various contexts depending on the asset.
- For convertibles, it's the profitable conversion point to stock.
- Parity compares currency values.
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