What is the parity price?
The concept of parity pricing is used for both securities and commodities, and the term refers to two assets of equal value. Convertibles, like convertible bonds, use the concept of the parity price to determine when it is financially advantageous to convert a bond into common shares.
Understanding the parity price
In addition to using the parity price for a convertible security, investors can use it to make investment decisions regarding commodities and currencies. The parity price can help determine the value of stock options, because parity is defined as the price at which an option trades 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 products, the parity price is the purchasing power of a particular product relative to a farmer’s expenses, such as wages, interest on loans and equipment. The Agricultural Adjustment Act of 1938 states that the parity price is the average price received by farmers for agricultural products over the past 10 years, and if the parity price of a product is lower than the current market price, government can provide purchase price support.
Key points to remember
- The parity price refers to the concept of comparing two assets of equal value.
- Depending on the type of asset it is used to value, parity prices can be used in a variety of different contexts. For example, this is the price at which it becomes profitable for investors to convert their bonds into common stocks. It can also be used to compare the value of two currencies.
Parity price: operation of convertible bonds
A convertible bond offers the possibility of converting into a fixed number of ordinary shares at a specific price per share. Investors buy convertible bonds because the owner can earn interest on a fixed income investment and has the option of converting it into the company’s equity. The parity price is the market price of the convertible security divided by the conversion ratio (the number of ordinary shares received during the conversion).
Examples of parity prices
Suppose, for example, that an IBM convertible bond of $ 1,000 has a market price of $ 1,200 and that the bond is convertible into 20 IBM common shares. The parity price is (bond market value of $ 1,200) / (20 shares), or $ 60 per share. If the market price of IBM common shares is more than $ 60 per share, the investor can benefit from the conversion into common shares.
When an investor buys a stock option, the owner has the right to buy a fixed number of shares at a stated price and the right to buy the shares expires on a fixed date. A Microsoft $ 50 call option, for example, means that the owner can buy 100 common shares of Microsoft at $ 50 per share before the option expires. If the Microsoft market price is $ 60 per share, the intrinsic value of the option is ($ 60 – $ 50), or $ 10 per share. If the stock option price is also $ 10, the options trade is at a par.