At a basic level, security is a financial asset or instrument with some monetary value. It’s negotiable, fungible, and can be bought, sold, or traded. Common examples of securities are stocks, bonds, options, mutual funds, and ETF shares.
Nowadays, there is practically no limit to the creativity finance people can use in developing new securities. These complex securities are primarily conceptualized because of the never-ending need of the investors and the market. However, don’t be dismayed. Today, I’ll break down the different types of securities so you can understand how they work.
Table of Contents
Three Primary Categories of a Security
- Equity securities – which includes stocks
- Debt securities – like bonds and banknotes
- Derivatives – which include options and futures
When institutions such as banks, corporations, or governments need to raise money to conduct business, they have two primary means of doing so. First, they can sell equity in the company in the form of common stock, whereby investors share in the company’s ownership. Another option is to create debt securities.
1. Equity Securities
“Equity securities” represent ownership interests in a legal entity such as a corporation, company, partnership, trust, or other business entity by way of shares.
Two Types Of Equity Securities
Generally, companies issue two types of equity securities: <span data-preserver-spaces=”true”>common and preferred shares.
Common stocks are ordinary stocks issued to the public to generate a stream of funding to expand the business. The main difference between common and preferred stock is that Common Stock represents the share in the company’s ownership position. By having ownership, you receive profits from the shares you own in the form of dividends. Additionally, you have the right to vote and participate in the company’s general meetings.
On the flip side, preferred stock is the share that gets priority in receiving dividends. However, preferred stockholders don’t get voting rights unlike common stock shareholders. But, at the time of liquidation, their claims are discharged first.
To better understand equity securities, think of shares you may buy in a publicly traded company on the stock market.
For example:
If you buy shares of Pepsi, you are buying equity securities or ownership interest in Pepsi.
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Other Types of Equity Securities
We also have hybrid types of equity securities, such as:
- Convertible bonds (callable bonds)
- Convertible stocks
- Warrants or equity warrants and
- Stock options
2. Debt Securities
Debt securities like bonds or debentures are debt instruments where one party (investor) lends money to the other (issuer). In turn, the lender receives interest for the money lent. Said differently, debt securities allow an institution to borrow money from investors and repay the loan with interest—the terms of the debt security agreement outline.
Why would a company issue debt securities? To borrow money to finance their business operations. In exchange, they promise to repay the face value of the sums borrowed along with a set interest rate.
Types Of Debt Securities
- Commercial Paper.
- Corporate Bonds
- Government Bonds
- Municipal Bonds
- Treasury Bills/Bonds (T-bills/T-notes)
For learning purposes, let’s talk about bonds.
Bonds - What Is a Security?
As you can see above, bonds come in a few different forms. However, they’re largely distinguished by the issuing institutions, which promise to make periodic interest payments until the value of the bond is repaid in full at a future date.
Government bonds are just that, bonds issued by the federal government. Backed by the credit and full faith of the U.S. government, they often act as a benchmark for the interest rates on debt securities. This is important because the risk of default is doubtful. After all, the government can always raise taxes or cut spending to make payments.
Municipal bonds, or muni bonds, are issued by state and local governments. Unlike federally issued bonds, their interest rate is higher as there’s more risk involved.
Companies issue corporate bonds to raise money to fund their operations. But, like municipal bonds, they, too, may be associated with more risk and offer a higher interest rate.
One benefit of investing in debt securities is the flexibility they offer. Additionally, debt securities provide higher yields than other debt instruments like savings accounts or CDs.
3. Derivatives
Last but not least are the derivatives.
Derivatives got their name from the root word ‘derive’ – they derive their value from other securities. For this reason, derivatives are one of the most challenging financial securities to understand.
The Most Common Derivatives
- Forward
- Future
- Options
- Swaps
Forward
A forward is a type of derivative where two parties agree to enter a buying and selling transaction. What differentiates a forward from other securities is that the agreed-upon trade hasn’t happened yet. The two parties will also agree today about how much the price will be at the time of exchange. Since nobody holds a crystal ball, forwards usually result in a loss for one party and a gain for another.
The interesting thing about a forward is that it’s an over-the-counter derivative. An over-the-counter market has no specific location, unlike an exchange. Generally, it involves transactions that happen privately between the parties involved.
To illustrate in a simplified manner, let us say Bob agrees to sell his products to Jerry at $100 per piece one year from now. However, due to unpredictable events, the product’s market value is $50 one year from today. In this scenario, Bob gains while Jerry loses. On the flip side, if the market value of the product turns out to be $200 after one year, then Bob loses while Jerry gains from the transaction.
From this scenario, you can see why people enter into this kind of transaction. The uncertainty about the future is reduced – you know how much the product will sell for. But whether or not you’ll be the one on the winning side is an entirely different story.
Futures Trading Course
Futures
A futures contract is quite similar to a forward contract. Once again, two parties agree to buy or sell a product at a particular price at a future date. This contract would also result in either party’s gain or loss. The most notable difference between the two is where they are traded.
A futures contract is traded in a futures exchange, while a forward contract is privately traded.
Therefore, futures are exchange-traded derivatives, while a forward is an over-the-counter derivative.
To understand it better, remember that an exchange generally means a market for financial securities with a physical location, just like the New York Stock Exchange (NYSE). This is why securities traded in these markets are referred to as exchange-traded.
Exchanges are highly regulated and standardized. Therefore, unlike over-the-counter markets, they don’t allow any wiggle room for customization.
Options
Generally, an options contract gives the owner the right to exercise the contract, but he cannot be forced to exercise it if circumstances are unfavorable to him. The most common kinds of options are put options and call options.
Now, differentiating these two is a bit tricky. The easiest way to understand them is through commonly using the words ‘put’ and ‘call .’When you put an object, you are putting or throwing it away from you. When you call someone, on the other hand, you are trying to make that person come near you.
In derivatives, a put option<span data-preserver-spaces=”true”> gives the owner the right to force someone to put away, or sell, the security. However, a call option<span data-preserver-spaces=”true”> gives the owner the right to force someone to call nearer or buy the security.
Rights Of Common Stock Holders
To summarize, holders of equity securities “may” have the following rights as far as the business is concerned:
- The right to sell off the Stock for profit
- The right to vote (ability to have an influence or control the company)
- The right to receive dividends (ability to receive profits distributions) if the board declares dividends
- In the event of liquidation or bankruptcy, the right to receive liquidation proceeds. However, all company debt and liability are paid first.
Final Thoughts - What Is a Security?
Trading the various types of securities can be both extraordinarily lucrative and risky. The truth is that without proper education and training, many lose money. For these reasons, you must take the time to research, study, and learn about the markets.
