What is 'Parity'
Parity refers to two things being equal to each other. The term "par value" for a bond is similar to parity. Parity can also refer to two securities having equal value, such as a convertible bond and the value of the stock if the bondholder chooses to convert into common stock.
In an exchange market, parity occurs when all brokers bidding for the same security have equal standing due to identical bids. When parity occurs, the market must determine which bidding broker will obtain the security by alternative means. Therefore, the winning bid is typically awarded by random draw. In foreign exchange markets, currencies are at parity when the exchange rate relationship is exactly one to one.
BREAKING DOWN 'Parity'
Many investors have to make decisions about the value of two different investments. A convertible bond, for example, allows the investor to own a bond and earn a stated rate of interest or convert the bond into a fixed number of shares of common stock. Assume, for example, that an investor can own a $1,000 corporate bond with a market price of $1,200 or convert the bond into 100 shares of common stock. If the stock’s market price is $12, the market value of the 100 shares of stock is also $1,200. As a result, the bond and the stock are at parity.
Factoring in Options
The term "parity" also applies to stock options. One call option, for example, allows the owner to buy 100 shares of stock at a specific price (strike price) for a stated period of time. Assume that an investor owns a $50 call option that expires on September 30. The investor has the right to buy 100 shares of stock at $50 per share until the expiration date in September.
The intrinsic value of an option is the difference between the strike price and the market price of the stock. If the stock's market price is $60 per share, for example, the option's intrinsic value is $10 per share. If the market price of the call option is also $10 per share, the option is trading at parity.
How Currency Trading Defines Parity
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 sends those euros to fund its French business operations. If the exchange rate is $1 to €1, the currencies are at parity.
Examples of Parity in Asset Management
Risk parity is an asset management process that evaluates risk based on asset classes rather than allocation of capital. Tradition asset allocation strategy divides assets between stocks, bonds and cash. The goal is to provide diversify and reduce risk by using these the types of investments. Risk parity, on the other hand, allocates dollars based on four components: equities, credit, interest rates and commodities. Risk parity attempts to reduce risk and increase investment returns.