Parity (Economics) - Explained
What is Parity?
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What is Parity?
In general, parity denotes a state of equality between two or more entities. The definition of parity has several implications.
In economics, the term parity can be used to describe either of the following
- An equality in the prices of discrete securities.
- An equal bid offered by various brokers bidding on the same security.
- An equal rate of exchange between two currencies traded in a foreign exchange (forex) market.
- Equality in the cash prices of two metals.
- Equality in purchasing power.
- Equal pay for equal work.
How is Parity Used in Economics
The concept of parity plays a vital role in the investment sphere. It especially aids investors in making investment decisions based on the values of two different market instruments. For example, an investor owning a bond may consider either of two options:
- Holding on to the bond in order to earn interest at a stipulated rate
- Converting the bond into a fixed quantity of common stock shares
In the above situation, assuming that the present market value of the bond is $1000, and each share of the common stock is worth $10 in the market, then the value of the bond will be exactly equal to the value of 100 shares of the common stock, thus signifying that the bond is at parity with the stock. Parity also plays a significant role in call options - arrangements that allow buyers to purchase underlying assets (such as stocks, bonds or commodities) at stipulated strike prices within assigned time frames. An investor buying such an asset aims to gain from a positive intrinsic value of the option (i.e. when the market price of the stock exceeds its strike price). When the market price of the call option equals its intrinsic value, it is said to be trading at parity. Currencies issued by two different countries can also be at parity at certain points in time. For example, the Canadian dollar was at parity with the U.S. dollar at least twice during trading sessions; once on November 25, 1976 and again on September 20, 2007. Similarly, metals traded in cash markets can be at parity with one another. For example, in late 2018, palladium prices were at parity with gold prices. Likewise, in early 2019, the prices of palladium futures were at near parity with gold futures.
Risk parity is an asset allocation strategy based on weighing risks associated with certain asset classes (e.g. equities and commodities) in lieu of evaluating allocation of capital. Risk parity is employed to diversify investments while maintaining focus on underlying risks and expected returns. Risk parity funds typically invest in market instruments such as stocks, bonds, currencies, and commodities by stipulating optimal risk target levels.
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