Imagine taking on the markets with a complete understanding of all the different financial securities available to invest, letting you choose between everything from stocks to ETFs to futures and options.
QUOTE
"If you don’t own stocks, you own something else. But there is no such thing as not investing. You are always invested in something."
Big ideas
Financial securities go beyond stocks and bonds to include funds and derivatives such as futures and options.
Securitization converts assets such as commodities or even mortgages into marketable securities, increasing market liquidity but also increasing complexity and risk.
Technology has expanded access to financial markets, shifted the dominance of institutional investors to individual investors, and changed traditional investment practices.
What are financial securities?
Definition
A financial security is a fungible, negotiable financial instrument holding some type of monetary value.
This encompasses instruments that operate as mediums for financial transactions, effectively representing an ownership position, a creditor relationship, or rights to ownership as stipulated by the terms of a contract.
You might be wondering, what’s the point of having financial securities in the first place? They serve several purposes above and beyond providing investment opportunities.
Financial securities, like stocks and bonds, serve key purposes:
Capital Raising: Companies and governments issue them to gather funds for operations or projects.
Investment: They offer individuals and institutions opportunities to invest and potentially earn returns.
Risk Management: Derivatives help manage risks like price fluctuations.
Economic Indicators: The performance of securities can reflect the economy's health.
Liquidity: Markets for securities allow quick buying and selling.
Diversification: Investing in various securities can spread and reduce risk.
Income Generation: Certain securities provide regular income, which is important for retirees.
The differences between stocks and securities
When we talk about stocks, we are talking about a specific financial security. Stocks, also referred to as shares, represent ownership in a company. Investors can invest in less than one share of a company by investing in fractional shares with Trading 212. As holders of shares, shareholders have a stake in the issuing company and declare their share of its assets and profits. This makes stocks an attractive investment opportunity as they can increase in value and pay dividends to their holders. On the other hand, securities is a far-reaching expression that incorporates so many other financial instruments, including shares. Securities can encompass debt such as bonds or derivatives. With a bond, an investor loans money to an issuer (like a business or government) for periodic interest payments and later receives the face amount of principal upon maturity. Derivative securities’ value depends on underlying assets such as stocks, bonds, commodities, interest rates and market indices.Crucially it should be understood that all stocks are securities, but not all securities are stocks. Types of financial securities
Securities can be divided into 4 categories:
Equity securities
Debt securities
Hybrid securities
Derivative securities
Equity Securities
Definition
Equity financial instruments refer to the ownership rights that stakeholders have in a company, represented as stocks. These stocks entitle their owners to a slice of the company’s assets and earnings proportional to how many of them they hold.
Pros of equity securities
✔️ Capital growth potential: Such financial instruments have ample room for relatively good capital growth. If the business prospers and profits increase, there is also a likelihood that the value of its shares might go up.
✔️ Dividend income: Some dividend-paying equities can be seen as a source of income to investors.
✔️ Voting rights: Generally, stockholders own rights that allow them to influence the direction their companies take.
Cons of equity securities
❌ Market volatility: The value of these securities can go down or up due to changes in market trends, economic conditions and, most importantly, performance by firms.
❌ No guaranteed returns: In contrast with debt instruments, stocks do not promise any returns. Thus, if an organization performs poorly, then all share purchasers lose their investments.
❌ Limited control: Usually, individual investors lack sufficient votes to substantially affect policies within organizations.
Debt Securities
Definition
Debt financial instruments are securities that were created to borrow money from an issuer (corporations, municipalities or governments) known as issuers on condition that this money be paid back with interest rates attached to them. Included under this category are bonds, debentures and notes.
Pros of debt securities
✔️ Stable income: Normally, they yield fixed interest rates meaning a constant stream of income is available from such securities as long as one holds them until maturity date.
✔️ Lower risk than equities: Usually, they are regarded as less risky when compared with equity instruments, particularly if issued by governments or stable corporations.
✔️ Priority in bankruptcy: Holders of debt securities get preference during liquidation before shareholders who have invested in equity securities.
Cons of debt securities
❌ Interest rate risk: For instance, some bonds may lose their value due to an increase in interest rates.
❌ Credit risk: It can happen that an issuer is unable to pay its obligations.
❌ Limited upside: For example, the price climbers on debt securities usually don’t exceed the offered interest rate, unlike equity holders.
Hybrid Securities
Definition
Hybrid financial instruments are complex financial instruments that combine aspects of both bond and shareholding agreements. Some examples include convertible bonds and preference shares, which provide for fixed interest earnings and a future option to exchange them into a predetermined number of ordinary shares.
Pros of hybrid securities
✔️ Flexible terms: Features such as conversion ratios and call options are often customizable.
✔️ Income and growth potential: They offer a mix between the stability in terms of earning from fixed-income securities and capital gains potential inherent in equities.
✔️ Priority over common stock: Generally, hybrids stand ahead of common shareholders whenever claims on company assets are settled during the liquidation process.
Cons of hybrid securities
❌ Complexity: Valuation and risk assessment may be complicated by their complexity.
❌ Lower priority than debt: In case of liquidation, they rank behind pure debt instruments.
❌ Market sensitivity: Fluctuations in market trends as well as modifications in interest rates, may affect hybrid securities significantly.
Derivative Securities
Definition
Derivatives are financial instruments that derive their worth from the value of an Underlying asset together with stocks, bonds, commodities, currencies and marketplace indexes. They encompass options, futures and swaps.
Pros of derivative securities
✔️ Risk hedging: Derivatives are widely used for the purpose of hedging against price changes in underlying assets.
✔️ Increased liquidity: This is because derivatives can be leveraged to give investors a much larger exposure at a fraction of the cost.
✔️ Wide range of strategies: These strategies may include speculation, arbitrage and hedging.
Cons of derivative securities
❌ Excessive risk-taking: The use of leverage can lead to massive losses as well as profits.
❌ Complex nature: Valuation and understanding derivatives can be difficult.
❌ Counterparty default risk: The risk that the other party in the contract will default on its obligations.
Asset-Backed Securities
Definition
Asset-backed securities (ABS) are financial instruments backed by a pool of assets, usually consisting of loans, leases, credit card debt, royalties or receivables. Examples encompass mortgage-subsidized securities (MBS) and collateralized debt obligations (CDOs).
Pros of Asset-Backed Securities
✔️ Risk spreading: Involves creating a more diversified portfolio for investors to benefit from.
✔️ Income producing: They usually pay regular payments based on the assets’ returns.
✔️ Risk mitigation: Consequently, there are credit enhancements put into place during their issuance so as to minimize default risks.
Cons of Asset-Backed Securities
❌ Complexity in valuation: The valuation of ABS can be complex, given their dependence on the performance of the underlying assets.
❌ Market risk: Susceptible to market conditions, particularly in real estate for MBS.
❌ Prepayment risk: The underlying assets (like mortgages) may be paid off early, affecting returns.
Other varieties of securities
Certificated Securities
Certificates of securities have been a typical investment tool that required a physical certificate. Their purpose was to show the ownership and set out the rights and responsibilities of the holder.
However, they are largely being replaced by paperless transactions in contemporary finance as compared to earlier times when they used to be very common. However, there are some investors who still love them due to their physical presence since there was tangible proof of investment.
Bearer Securities
Issued as physical certificates, bearer securities are unique in that they belong to anyone who holds the paper, very much like cash. In this type of security, the owner’s name is not entered and there is no need to register the transfer of ownership.
Anonymity comes with bearer securities but it also exposes them to risks such as theft or loss since possession of the certificate confirms ownership.
Registered Securities
Registered securities are issued in a name and tracked by the issuing company or its agent, ensuring that all ownership changes are recorded.
Registered securities differ from those held by bearers because clear ownership established provides greater security and ease in transferring ownership. It is commonly used for stock and bond trading due to its safety and ease of tracking ownership.
Letter Securities
Sometimes referred to as restricted securities, are not registered with the Securities and Exchange Commission and are typically issued directly to investors in private offerings.
Often these have restrictions on their sale and are mostly kept by insiders of the firm or large institutional investors. Their name comes from the “letter” (typically SEC Form 144) that an investor must sign indicating his/her agreement with the sale limitations.
Cabinet Securities
These cabinet securities, sometimes referred to as “cabinet stock” or “cabinet trades,” fall under a separate trading category due to their low trading volume.
Essentially, these are non-traded securities that may stay in a broker’s cabinet until someone wants to buy or sell them. Cabinet securities generally consist of bonds or other fixed-income investments that mostly belong to institutional investors who prefer these assets for their stability and long-term value.
Recap
Stocks, bonds, hybrids and derivatives are all considered financial securities. Sure, they all have their own distinct characteristics, but what are they? Stocks give people the opportunity to get capital growth, dividends and ownership in a company. However, that also comes with risk.
If you’re not willing to take on that risk or are looking for a safer investment then consider bonds which are like loans to governments or corporations that offer stable income and lower risk.
Now if you’re feeling for something more complicated, then there are hybrid securities, which combine features of both stocks and bonds. Then there are derivative securities which is exactly what it sounds like; it’s based on the value of underlying assets and used for both speculation and risk hedging.
FAQ
Q: What are the 4 types of securities?
Equity securities (like stocks), debt securities (think about bonds), derivatives (which include futures, and options) hybrid securities blending elements from both debt and equity.
Q: What is financial security in the UK?
Financial security in the UK refers to tradable assets such as stocks, bonds etc. They’re tools used by individuals or organizations either as investment tools or as financing tools.
Q: What are the 3 types of equity securities?
Common Stocks / Preferred Stocks / Convertible Securities.
Q: Why are they called securities?
They provide security! Not only do they represent a secured, tradable financial interest in an asset but also in a company or government.
Q: What is another word for financial security?
Financial Stability is another word that could be used to describe it. Which is the same sense of having more than enough money and resources to meet current and future needs.
Q: Are securities assets or equity?
Securities can be both! For example, stocks (equity securities) represent ownership in a company (an asset), while bonds (debt securities) are considered financial assets to the holder.
Q: Are securities debt or equity?
Securities can also be both! Debt securities - bonds - are loans made by buyers to the issuer; on the other hand, buyers get possession of a company with equity securities - stocks.
Q: Is gold considered a security?
Gold itself is not considered a security because it's just an object, after all. However, there are financial instruments where you own parts of that same piece of metal, like ETFs or gold mining company stocks, which would then be classified as one.
Q: What is the difference between bonds and securities?
Bonds fall under the category of being a security itself, specifically debt security. Bondholders have money owed to them by whoever issued it. The issuer must pay interest and/or repay the principal at a set date. Securities cover more than just bonds, though. It also includes derivatives and more.
Q: Why do investors buy securities?
There are varying reasons as to why people would potentially buy stocks and bonds. Some of them may be a potential for capital gains, generating income through dividends or interest, a way to diversify portfolios, and serving as a hedge against other investment risks.