Conversion parity definition
Conversion parity is a condition that exists when a particular convertible security can be sold on the open market for a price that is equivalent to the cost of its underlying assets. Convertible securities offer investors the option to convert the value of the security into the underlying assets, usually shares of common stock; therefore, conversion parity is typically an ideal concept rather than one that is frequently available in actual practice.
Conversion parity price
The conversion parity price of a convertible security is derived by dividing the price of the convertible by the conversion ratio. Conversion ratios are essentially the number of shares into which each convertible security can be converted; therefore, the formula for calculating the conversion parity price can be expressed as:
- Conversion parity price = price of convertible security / conversion ratio
Conversion parity investments
Because conversion parity represents neither a loss nor a profit to the investor, it is generally used as a benchmark figure. When the price of the underlying stock increases, the selling price of the convertible security usually rises as well, offering the potential for profit to the investor. If stock prices fall, however, the investor may experience significant losses in profitability, depending on the provisions of the convertible security. Most convertible securities ensure a minimal level of return, making these investments a lower-risk choice for investors.
Convertible bonds and conversion parity
In the convertible bond market, conversion parity is one of the most important indicators used to determine the relative desirability of various bond options. Because convertible bond investments are considered safer than purchasing common stock, they are a solid investment for risk-averse investors; however, in some cases they can produce yields equivalent to those available from common stock purchases. Convertible bonds are also desirable due to their flexibility; investors can opt to convert to stocks when the conversion parity price makes such a move profitable. Conversion parity price figures can help investors determine where the best potential for profit will arise. Convertible bonds are useful as hedges against economic declines and bear markets, since they typically put a floor under the potential losses while offering the opportunity to take advantage of any available profits when and if the underlying stocks do increase in value.
Conclusions on conversion parity investments
Typically convertible securities offer lower returns on investment than outright purchases of stock, but feature a lower risk factor as well. Investors should avoid convertible securities with less profitable conversion parity figures or those that feature a call option for the issuer, since these can further limit potential profits when they arise.