Parity

Trading Basics

Parity

Quick Summary: Parity is when two things are equal. This can occur in many different situations, such as the exchange rate for two currencies being 1 to 1, or two traders bidding exactly the same price for a security.

Full Overview: The concept of price parity is commonly used by investors across different markets to describe two assets that are equal in value. Price parity can be used in all major markets, including the stock market, currency market (Forex), commodities, bonds, and options.

Besides price parity, parity can also refer to parity in exchange rates, inflation rates, interest rates, or any other macroeconomic variable. In the following lines, we’ll cover what parity means in different financial markets and how market participants use it to make trading decisions.

Parity in Options

In the options market, price parity helps investors to measure the value of stock options. An option is said to be in parity if the price of the option is trading at its intrinsic value.

The intrinsic value of an option tracks the price of the underlying security but also other important characteristics of the option itself, including its expiration date and the strike price, for example.

Parity in Forex

In the Forex market, traders and investors use price parity to find overvalued and undervalued currencies and to build a trading strategy around the principle of mean reversion, which basically says that undervalued currencies have to rise against overvalued currencies over time. In a simper form, parity in the Forex market can also refer to parity in exchange rates when the base currency buys exactly one counter currency. For example, if the EUR/USD pair is trading at 1.00, the pair is said to trade at parity.

To arrive at the price parity for a currency pair, market participants often use the Purchasing Power Parity, which uses the exchange rate that equals the purchasing power of two currencies. The PPP concept is used to find currencies that are trading above or below that fair (parity) value. Traders who use the parity concept in their trading would try to sell currencies that are overvalued and buy currencies that are undervalued, hoping that the market exchange rate will return to the parity level over time.

A major drawback of using the PPP concept in trading is that it returns mixed results over the short-term. Currencies can stay overvalued and undervalued against other currencies for a long period of time, sometimes even for years. That’s why short-term traders should look into other tools to base their trading decisions on.

Read:

The History of the Forex Market

Big Mac Index

A popular tool that uses the PPP model as its basis is the Big Mac Index. The Big Mac PPP compares the price of a McDonald’s Big Mac in different countries to identify what currencies are trading above or below their fair value. A Big Mac is a homogenous product: It’s the same burger whether you order it in Germany or Russia. If a Big Mac costs €3 in Germany and 210 rubles in Russia, the parity exchange rate of EUR/RUB would be 70, i.e. one euro buys 70 Russian rubles.

If the market exchange rate differs from the Big Mac PPP rate, traders could buy the currency that is undervalued according to the PPP model.

While the Big Mac PPP could sound like pseudo-science to some traders, it’s interesting to note that this model accurately predicted the misalignment in the EUR/USD exchange rate in the early 2000s. Most market analysts were wrong in the direction the single currency would take in the coming months, while the Big Mac PPP was spot on.

Parity in Convertible Bonds

Investors also use the price parity concept when trading with convertible bonds. Those types of bonds allow investors to convert the bonds into a fixed number of common stock at a specific price, providing the investors with a flexible fixed-income instrument that can be converted into the company’s equity.

For example, let’s say that a GM convertible bond has a market price of $600 and can be converted into 20 shares of General Motors. If the current stock price is $40, the investor could make a profit of $200 by converting the GM bond into common stock ($40 x 20 shares = $800).

Final Words

Price parity is an important concept that is used by market participants in different financial markets. In the options market, price parity is used to measure the intrinsic value of options and to make trading decisions based on it.

Parity is also an important concept in the Forex market, where parity is defined as the exchange rate that equals the purchasing power of two currencies. The PPP model is used by Forex traders to take advantage of differences in the purchasing power, but it can take months or even years for currencies to revert to their fair value.

Parity is also used in the bond market to define the best time to convert a convertible bond into common stock of a company.

 

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