Financial securities are tradable and interchangeable financial instruments, like stocks, bonds, or exchange-traded funds (ETFs), that represent a specific financial value. To qualify as a security, it must be possible to buy, sell, or trade it on the market, ensuring liquidity and negotiability.
What is a security?
Securities are tradable financial instruments employed to procure capital within public and private markets. Primarily categorised into equity, debt, and hybrid instruments, they offer distinct investment avenues. Equity securities represent ownership stakes, while debt securities constitute loans with predetermined repayment terms. Hybrid securities exhibit characteristics of both equity and debt. Common examples include stocks, bonds, and derivatives. These instruments underpin the functioning of capital markets, enabling investors to participate in asset ownership, trade, and risk management.
Types of securities
In the world of finance, there are several different types of financial securities.
1. Equity securities
Equity securities, commonly known as stocks or shares, represent ownership in a company. When you own equity securities, you own a portion of the company's assets and have the potential to earn profits through capital appreciation and dividends. Equity shareholders also have a voice in the company's decisions through voting rights. Investing in equity securities carries the potential for high returns, but it also comes with a higher level of risk compared to other types of securities.
2. Debt securities
Debt securities, on the other hand, represent loans made by investors to governments, corporations, or other entities. These securities include bonds, debentures, and notes. When you purchase a debt security, you are essentially lending money to the issuer in exchange for regular interest payments and the promise of principal repayment at a future date. Debt securities are considered lower-risk investments compared to equities, as they offer a predictable stream of income and are backed by the issuer's creditworthiness.
3. Hybrid securities
Hybrid securities combine features of both equity and debt securities. Convertible bonds and preference shares/ preferred stocks are common examples of hybrid securities. Convertible bonds allow bondholders to convert their bonds into a predetermined number of company shares, providing the potential for capital appreciation along with the safety of a fixed-income investment. Preferred stocks, while similar to common stocks, offer preferential treatment in terms of dividends and liquidation proceeds, making them a middle ground between equity and debt investments.
4. Derivative securities
Derivative securities derive their value from an underlying asset, such as stocks, bonds, commodities, or currencies. Options and futures contracts are prominent examples of derivatives. Options provide investors the right, but not the obligation, to buy or sell an underlying asset at a specified price within a certain timeframe. Futures contracts obligate traders to buy or sell an asset at a predetermined price on a specific future date. Derivatives are commonly used for hedging against price fluctuations, speculating on market movements, and managing risk.
5. Asset-backed securities
Asset-backed securities (ABS) are financial instruments backed by a pool of underlying assets. These assets can range from mortgage loans and auto loans to credit card receivables. The issuer packages these assets into securities that are then sold to investors. ABS offer an opportunity for diversification and can be structured to cater to different risk appetites. Mortgage-backed securities (MBS), for instance, pool together various mortgages and provide investors with a share of the interest and principal payments from these mortgages.
Other forms of securities
Apart from the financial securities mentioned above, global markets also include the following types of securities:
1. Bearer securities
Bearer securities are financial instruments that confer specific rights upon their holder. Unlike registered securities where ownership is recorded, bearer securities are not registered in the name of any specific individual. Instead, the physical possession of the security is considered proof of ownership.
2. Letter securities
Also known as letter stock or letter bond, a letter security is sold directly by the issuer to the investor. The term derives from the SEC’s mandated investment letter requirement from the purchaser, stating that the purchase is for investment purposes and not resale.
3. Cabinet securities
Cabinet securities refer to financial instruments that are listed on a prominent stock exchange but exhibit exceptionally low trading volume. This characteristic distinguishes them from actively traded securities, which experience frequent buying and selling activity.
4. Mortgage-backed securities
A mortgage-backed security is a type of asset-backed security that is collateralised by a collection of mortgages. In simple terms, it is a type of bond secured by real estate loans.
5. Residual securities
Residual securities are convertible securities that can be changed into a different type of financial security, usually common stock. Corporations generally offer residual securities to encourage investors when the competition for funds is intense.
6. Registered securities
Registered security is a type of security that has the name and other details of the holder on the official register of the issuer.
7. Certificated securities
Certificated securities are those that are represented by a physical certificate. When an investor buys a certificated security, they are entitled to a certificate that proves such ownership.
8. Security baskets
A security basket is a collection of different types of securities following a central theme, investment strategy, sector, or industry. ETFs and mutual funds are common examples of security baskets.
How securities are traded?
To understand financial securities better, let us understand how different securities are traded in different markets:
1. Stock exchanges
Publicly traded securities like equity stocks are listed on stock exchanges. An IPO (Initial Public Offering) of a company represents the first time equity is offered to the public. Post the IPO, any newly issued stock is called a secondary offering.
2. Over-the-counter (OTC) markets
OTC markets are decentralised markets where buyers and sellers can trade with each other directly, without the involvement of an exchange or a broker. Usually, stocks, bonds, and ETFs not listed on national stock exchanges are traded on OTC markets. Securities like derivatives can be traded on regulated stock exchanges or over the counter.
3. Private placements
Some financial securities may not be listed publicly. Instead, they may be offered privately to a qualified and restricted group of select investors. This is known as private placements. Sometimes, corporations combine a public and private placement strategy to sell stock and raise capital.
Role of securities in finance
Financial securities play a crucial role in the world of finance in the following ways:
1. Portfolio diversification
Investors use different asset allocation methods to diversify their investment portfolios with different types of financial securities. A diversified portfolio with a healthy mix of assets helps protect investors against market volatility.
2. Risk management
Financial securities play a key role in risk management as well. Securities with low or zero correlation can be used to hedge investment risks and offset losses arising from a particular asset class. For instance, equity and gold have a negative correlation. Therefore, investors can hedge risks of equity investment by investing a portion in gold ETFs.
3. Raising capital
Securities are tradable instruments used to raise capital in public and private markets. Both corporations and governments issue financial securities to raise the capital required for funding various operations. Instead of applying for a costly loan, corporations list equity shares on the stock market to raise capital for growth and expansion. Similarly, governments sell bonds to raise funds for various projects to ensure the development of the country.
4. Maintaining market liquidity
Securities are also crucial in maintaining market liquidity. Since there are multiple readily available buyers and sellers of any given type of financial security, these instruments can be converted into cash more easily than other assets like, say, real estate.
5. Reflect the health of the economy
Financial securities serve as a barometer for the economy’s overall health. For instance, investors often assess the health of the economy by analysing the stock market. The logic is simple: If the equity shares of companies are performing well, the companies linked to them are probably performing well too.
What is the difference between stocks and securities?
Stocks and securities are closely related financial instruments, but they have distinct characteristics.
Stocks, often referred to as "equities" or "shares," represent ownership in a specific company. When you buy stocks, you become a shareholder and have a claim on a portion of the company's assets and earnings. Stockholders may have voting rights and can benefit from capital appreciation and dividends.
Securities, on the other hand, is a broader term encompassing various tradable financial instruments. While stocks are a type of security, securities can also include bonds, mutual funds, options, and other financial assets. Securities represent a financial interest or a right to assets or income and can be traded in financial markets. Unlike stocks, which represent ownership, securities can represent both ownership and debt.
What are marketable securities?
Marketable securities are liquid financial assets that can be quickly bought, sold, or traded on public markets with minimal impact on price. Examples include stocks, bonds, and treasury bills. Their high liquidity makes them suitable for short-term investments, as they can easily be converted into cash. These securities are popular among investors looking for flexibility and quick access to funds under normal market conditions.
What are treasury securities?
Treasury securities are government-issued debt instruments designed to raise funds for public expenditures. Backed by the U.S. government, they offer low-risk, reliable returns, making them attractive to risk-averse investors. Common types include Treasury bonds, notes, and bills.
Conclusion
In a rapidly evolving financial landscape, securities serve as building blocks for constructing investment portfolios, managing risks, and enabling capital formation. Investors choose securities based on their risk tolerance, investment goals, and market outlook. It's important to note that each type of security carries its own set of risks and potential rewards. Diversification, or spreading investments across different types of securities, is a common strategy to mitigate risk and optimize returns.
As you delve into the world of securities, it's essential to educate yourself about the intricacies of each type and how they fit into your overall financial strategy. Whether you're seeking the potential for high returns, stable income, or a balance between the two, there's a securities category that aligns with your objectives. However, keep in mind that no investment is entirely risk-free, and a thorough understanding of securities will empower you to make well-informed decisions that can lead to financial success and security.
