Parity is a financial term that has a variety of uses, but generally describes situations where two or more objects or individuals are considered equal in some way. Underlying this concept of parity is the idea that one or more different objects are equal or relatable in one or more ways.
Parity and Convertible Bonds
Convertible bonds offer the opportunity to convert the bond into a fixed number of equity shares. This opportunity gives the bond holder the option of transforming their interest generating debt instrument into a dividend generating equity instrument. The price for the bond’s shares is then the price of the bond divided by the number of shares awarded upon conversion.
For example, if the price of the bond is $1,000 and it can be converted into 50 shares, then then price of the bond’s awarded shares is $20 ($1,000 / 50 shares).
Parity and Commodities
Prices are used in commodity production by governments looking to subsidize producers, usually in agriculture. The price of a given commodity is the price of production to the producer to produce one unit of that commodity, generally in terms of labor, equipment and interest on associated loans. Prices for commodities are generally averaged over some time period, usually 5 or 10 years.
For example, if the total cost to produce a bushel of grain this year was $5 and last year was $7, then a bushel of grain could be considered to have a parity price of $6.
If the market price for a commodity is below the parity price, then a government may consider providing a subsidy to the producer of the commodity.
The parity price for stock options occurs when the price of the options is equal to the profit from exercising the option.
For example, a call option for company A at $50 gives the holder of the option the right to buy 1 share of company A at $50. If the market price of the shares is $60, then the parity price for the options would be $10 ($60 – $50).
Parity is used in many market situations to place limits on the actions of participants to make them equal in one or more respects. For example, a bond auction may limit the volume that any one participant may purchase to ensure that participants with a greater capacity to spend do not influence the auction price more than other participants.
Risk parity is a portfolio management theory that alters the make-up of the various asset classes in a portfolio (equity, bonds, commodities, cash) in an effort to maintain a steady rate of risk. As market circumstances change, the relative risk between certain asset classes will also change, so the portfolio manager will adjust the ratio of the asset classes within the portfolio to maintain a steady rate of risk given the new market circumstances.
Parity is an important concept for traders to understand as it relates to how the market is able to come to a variety of different price equilibrium across different assets. Exchange rates, inputs and risk parity strategies all require prices to adjust according to an equilibrium chain that keeps everything in balance.
This concept is particularly important in arbitrage trading, as traders who are able to rapidly identify any lack of equilibrium according to price parity formulas can exploit these gaps for profit. Market forces will often pressure prices to conform to parity price formulas, which leads to the ability to forecast price changes. Similarly, risk parity and other parity strategies force portfolio managers to make certain purchases and sales to maintain the defining parity in their strategies, which represents further opportunities to make solid price forecasts.
Parity is a product of the working of efficient markets. When markets are working at full efficiency, there should be no divergence between parity prices and current market prices. However, markets often fail to operate efficiently for a wide variety of reasons. In these circumstances, traders who understand the origin of the parity prices and the forces that work to push market prices toward parity prices have the opportunity to profit from arbitrage trades.
Parity can also force market participants to act in predictable ways when used as the basis for trading strategies, which presents additional profitable trading opportunities.