What Is Parity Price?
The parity price concept is used for both securities and commodities, and the term refers to when two assets are equal in 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. If two assets are trading at parity, it can be inferred they are at the same price or value.
- Parity price describes a price level in two or more assets that represent equal or equivalent value.
- Depending on the type of asset that it is used to price, parity prices can be used in a variety of different contexts.
- Parity is the price at which it becomes profitable for investors to convert their convertible bonds into shares of common stock. It can also be used to compare the value of two currencies.
Understanding Parity Price
Parity is a term used to describe when two things are equivalent to one another. 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.
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.
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 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.
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 pounds 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.
Parity Price: 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).
Examples of Parity Prices
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.
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.