What is a 'Parity Price'
A parity price is when the price of an asset is directly linked to the price of another asset. The parity price concept is used for both securities and commodities, and the term explains when two assets have an equal value. Convertibles, such as convertible bonds, use the parity price concept to determine when it is financially beneficial to convert a bond into shares of common stock.
!--break--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, as parity is defined as the price at which an option is trading at its intrinsic value. The concept of parity is also used to compare the value of two currencies.
How Convertible Bonds Work
A convertible bond offers the opportunity to convert 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 has 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).
Assume, for example, that a $1,000 IBM convertible bond has a market price of $1,200, and that 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 into common stock.
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 states that the parity price is the average price received by farmers for agricultural commodities during the previous 10 years, and if the parity price for a commodity is below the current market price, the government may provide price support through direct purchases.
Examples of 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.