What is Meant by Parity?
Parity refers to the condition where two items (or more) are equal. Therefore, if the bondholder wants to convert into common stock, it can refer to two securities having equal interest, such as a convertible bond and the value of the share.
For a bond, the phrase "par value" is close to parity. It implies that the bond sells for its original face value.
Alternatively, parity can be found in the foreign exchange markets where currencies that are at parity have an exchange rate relationship of one-to-one.
In a financial security market, parity occurs when all brokers bidding for the same security are of equal standing due to similar bids. When parity exists, the market must decide which bidding broker will use alternative means to obtain the protection. Thus, the winning bid is usually awarded by random draw.
Applications of Parity
In relation to Stocks and Bonds
Investors have to often decide between two different investments based on value. For example, a company's convertible bond allows an investor to own a bond as well as earn a rate of interest. But the bond has an option for the holder to convert the bond into a fixed number of equity shares. Therefore, the bond and the stock are at parity.
In the Forex Markets
In the foreign exchange (forex) markets, currencies are at parity when there is a 1:1 relationship for the exchange rate. Companies based in the United States that have operations in foreign countries must convert U.S. dollars into other currencies. Assume a situation where the exchange rate is $1 to €1. Then, the currencies are considered to be at parity.
In the Economy
Purchasing Power Parity (PPP) refers to a method of comparing the purchasing power between countries. PPP weighs the cost of a basket of goods in one country by the cost of the same goods in another country.
But the purchasing power parity adjusts for the exchange rates between the two countries. So, the two similar products should be the same price in both countries after figuring for exchange rates.
Undoubtedly, parity cannot be attainable in the real world for a reason. For example, the price of the Indian iPhone could vary due to other factors unique to India only, such as the distribution cost, packaging, or local regulations.
Overview of Risk Parity
Risk parity refers to a portfolio allocation strategy using risk to determine allocations across various investment portfolio components. The strategy for risk parity follows the modern portfolio theory (MPT) approach to investing that looks to diversify a portfolio of investments among specified assets to optimise returns.
The market risk parameters must be adhered to by viewing the risk and returns for the entire portfolio. The graphical representation of a Security Market Line (SML) is a part of this approach.
