A security is a financial asset or instrument that has value and can be bought, sold, or traded. Some of the most common examples of securities include stocks, bonds, options, mutual funds, and ETF shares. Securities have certain tax implications in the United States and are under tight government regulation.
Characteristics of Financial Securities
- Securities are fungible. In other words, they are assets that can be exchanged quickly and easily for others of the same type. Just like any one nickel can be replaced by any other, any share of a company’s stock can be replaced by any other share of the same company’s stock. While both nickels and a company’s shares can change in value over time, at any one moment in time, all nickels are worth the same amount, and all shares of a specific company’s stock are worth the same amount.
- In the United States, the exchange of securities is regulated by the SEC (Securities and Exchange Commission), a regulatory agency of the U.S. government.
- The legal definition of a financial security varies between countries and jurisdictions.
- Securities are usually divided into four general categories—debt, equity, hybrid, and derivative.
The 4 Types of Securities
Financial securities are divided into one of four general categories—debt securities, equity securities, hybrid securities (which have characteristics of both debt and equity securities), and derivative securities.
Debt Securities
Debt securities—like corporate, government bonds, and certificates of deposit—are essentially loans. They act like IOUs from a government or corporation to the debt security holder.
Owners of debt securities lend a certain amount of money (the principal) to another party. That party is then obligated to pay pre-determined interest payments to the owner at regular intervals per the terms specified in their agreement until the instrument matures, at which time the debtor must pay back the security owner in the amount of the principal.
The purpose of a debt security (like a bond) is twofold. On one hand, it allows a corporation, government, or other entity (the borrower) the temporary use of the security owner’s capital. On the other hand, it allows the security owner to receive regular interest payments for a period of time in exchange for the temporary use of their money before having it returned to them in full at a certain agreed-upon date.
2. Equity Securities
Equity securities indicate partial ownership of an entity—often a business. The most common example of an equity security is a share of a company’s stock. Shares of mutual funds are also considered equity securities, as are shares of certain ETF’s (those that do not include debt securities like bonds).
While individuals purchase debt securities in order to receive periodic payments in exchange for the temporary use of their money, individuals usually purchase equity securities as investments for the purpose of realizing capital gains over time. An equity security is an asset, so if its value increases, the party that holds it can sell it for a profit.
While most equity securities usually do not entitle their holders to periodic payments, some do, and these payments are called dividends. Companies that pay dividends use a small percentage of their profits to pay shareholders a certain amount of money per share—usually once per quarter or once per year. Because holders of equity securities are partial owners of an entity, they are also often entitled to certain voting rights when it comes to some of that entity’s business decisions.
Generally, equity securities offer higher potential returns than debt securities because a company or entity’s value is technically limitless, whereas a bond’s interest payments and maturity date are fixed and pre-determined.
Equity securities also come with greater risk, however. While a company or entity’s potential value is limitless, that value could also change in a negative direction, resulting in capital losses for shareholders. If a business goes bankrupt, its shareholders are only entitled to their portion of whatever value remains after the business has paid all of its creditors and fulfilled all of its obligations per the terms of the bankruptcy.
Hybrid Securities
Hybrid securities behave like debt securities in some ways and like equity securities in other ways. The most common type of hybrid security is a convertible. These behave like bonds in that they involve regular payments, but they differ from bonds in that they can also be converted into a specific number of shares of a stock at the holder’s discretion. Another example is an equity warrant, which is an option issued directly by an entity to its shareholders to buy or sell a security for a specific price on or before a specific date.
4. Derivative Securities
A derivative is a security whose value is based on a specific asset or group of assets (like a stock or commodity). A derivative usually takes the form of a contract between two parties relating to the purchase or sale of a specific asset or pool of assets. Derivatives are often used by individuals and institutions to mitigate risk, but they can also be used speculatively by investors to make money.
One common derivative is a futures contract, which is an agreement to buy or sell an asset at a pre-determined future date for a specific price. If someone were to purchase a futures contract that entitled them to purchase a bale of hay for $35 dollars in three months, but by the time three months had passed, bales of hay were worth $45, the buyer would realize a $10 gain. Forward contracts behave similarly, but they are more customizable and typically carry more risk for both buyer and seller.
Options contract are also common. These behave like futures, but instead of the buyer being obligated to purchase or sell a specific security at a specific price at a specific point in time, they simply have the option to do so.
Another common derivative is a swap, which is an agreement between two parties to exchange one cash flow for another. One cash flow is usually fixed (like a fixed interest rate), and the other is usually variable (like a variable interest rate). Sometimes, companies swap loan interest rates in different currencies to take advantage of exchange rates.
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