What are Securities?
Definition: Securities are a prominent feature of the investment universe but, what do they stand for? By definition, a security is a debt or a proof of ownership that has monetary value and that the owner can sell. The owner of the security considers this financial instrument as an investment. The owner of the security has evidence, usually in the form of a computer file.
However, this definition is quite simplistic from the perspective of the Securities and Exchange Act of 1934. According to the Act, a security is any financial instrument that enables one party to access funds and the other party to earn profits. The Act lists many instruments that qualify as securities, which include stock, swap, debenture, bond, certificate of interest, collateral-trust certificate, and more.
Types of Securities and Examples
From a broad perspective, there are three types of securities:
- Equity securities
- Debt securities
- Derivative securities
Let’s take a look at each to see what types of investments are included in each and how they are different from each other.
Equity Securities
Equity securities are financial instruments that give you ownership of a piece of a company. Usually, equity securities are simply stocks or shares of a company that investors purchase from either the primary stock market or the secondary stock market. Before an investor can purchase the equity, a company has to go public first in what is called initial public offering (IPO). During an IPO, a company sells its shares to investors in bulk. This first sale happens in the primary market. Then, the initial buyers can take the shares to the secondary market, commonly called the stock market, where retail investors buy and sell among themselves.
A shareholder/equity holder has a say on the business activities of the company. This is because the business performance affects the value of its stock. For example, when a company announces record-breaking financial numbers, many investors will want to exploit the profit potential of the company. Resultantly, the ensuing demand for the company’s stock will increase its price. This presents an opportune moment for stockholders to sell at a profit. Nonetheless, many other factors cause the fluctuation of the price of the stock. As such, equity securities are a high-risk investment vehicle.
Debt Securities
Simply, this type of securities represents an investment in debt. Typically, bonds are the ultimate representation of debt securities. When an investor buys a bond, one is simply loaning money to the bond issuer. Usually, the issuer offers an assurance to pay the money back on the date of maturity. However, the bondholder earns periodic payments at a fixed rate. As such, debt securities also go by the name fixed-income securities. Other examples of debt securities include certificates of deposit, treasury bills, commercial paper, repurchase agreements, and more.
Technically, debt securities are safer investments for investors compared to equity securities. This is because they offer fixed-income and they have a pre-determined maturity date. To be sure, the predictability of debt securities is reassuring but that does not mean they carry no risk. Specifically, no one can rule out the possibility of a bond issuer to default on repaying investors upon the maturity of the bonds. Also, the price of government bonds fluctuates due to interest rate fluctuations. A high-interest rate leads to cheaper bonds and vice versa.
Derivative Securities (derivatives)
These securities derive their value from underlying assets like equity securities, debt securities, and other assets like a mortgage. Instead of buying the asset to gain profit, an investor buys its derivative but whose value depends on the underlying asset performance. Examples of such derivatives include stock options, futures contracts, and mortgage-backed securities (MBS).
The defining quality of derivatives is that they use leverage to facilitate high returns relative to invested capital. However, the derivatives amplify loss the same way they amplify profits. Subsequently, these securities carry the biggest risk in the securities market. Notwithstanding, their introduction expanded the opportunities for investors to earn income and hedge their investments. This is because investors can even bet against stock and earn a handsome profit.