What Is Parity?

Parity refers to the condition where two (or more) things are equal to each other. It can thus 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. The term "par value" for a bond is similar to parity in that it suggests the bond is selling for its initial face value. The term "parity" is often applied in the financial markets when dealing with stocks, bonds, and currency exchange rates.

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Risk Parity

Key Takeaways

  • Parity refers to the condition where two (or more) things are equal to each other.
  • Parity can 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.
  • Parity can also be found in the foreign exchange markets whereby currencies that are at parity have an exchange rate relationship of one to one.

Understanding Parity

In a financial market where there's an exchange of a security or investment taking place, 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. The winning bid is thus typically awarded by random draw.

Parity with Stocks and Bonds

Many investors have to make decisions about the value of two different investments. A convertible bond issued by a company, for example, allows an investor to own a bond and earn a rate of interest. However, the bond comes with the option to convert the bond into a fixed number of shares of common stock.

Assume 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.

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 sends those euros to fund its French business operations. If the exchange rate is $1 to €1, the currencies are at parity.

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, the 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 to the U.S. dollar is $1.30 (it costs $1.30 for each British pound). So, in Britain, if an iPhone costs approximately 460 pound sterling, there would be parity in purchasing power since 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.

Of course, parity isn't always achievable in the real world since the price of the British iPhone could differ due to other factors unique to Europe, such as the cost of distribution, packaging, or local regulations.

Risk parity attempts to reduce risk and increase investment returns.

Special Considerations

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.