SECURITY AND ITS TYPES – ALL YOU NEED TO KNOW
A security is a financial instrument, typically any financial asset that can be traded. The nature of what can and can’t be called a security generally depends on the jurisdiction in which the assets are being traded.
“Securities” refers to substitutable and tradable financial instruments with a particular monetary value. This represents the ownership of a listed company through its shares. The legal entity’s bonds represent creditor relationships with government agencies or businesses or optional ownership.
For laymen, securities are financial assets of monetary value that investors use to invest in a company, while companies use them to raise capital. In India, securities are defined under the Securities Contracts (Regulatory) Act of 1956. Under Section 2 (h), securities include “shares, scrips, stocks, bonds, debentures, debenture stock or other marketable securities of a like nature in or of any incorporated company or other body corporates. Companies Act 2013 also refers to the exact definition, and under Section 2 (81), securities have the same meaning
- Security is a financial instrument that can be traded between parties in the open market.
- The four types of security are debt, equity, derivative, and hybrid securities.
- Holders of equity securities (e.g., shares) can benefit from capital gains by selling stocks.
Types of Securities
There are four primary types of securities:
Equity securities: An equity security is a share of ownership in a company, trust, or partnership. Equity securities are usually shares of common stock, but can also be preferred stock. When the issuer of equity security generates a profit and retains earnings, the issuer often pays out some earnings to shareholders by way of dividends. Equity securities can increase or decrease in value depending on the performance of the company and the financial markets.
Debt securities
Debt securities differ from equity securities in an important way; they involve borrowed money and the selling of a security. They are issued by an individual, company, or government and sold to another party for a certain amount, with a promise of repayment plus interest. They include a fixed amount (that must be repaid), a specified rate of interest, and a maturity date (the date when the total amount of the security must be paid by).
Bonds, bank notes (or promissory notes), and Treasury notes are all examples of debt securities. They all are agreements made between two parties for an amount to be borrowed and paid back – with interest – at a previously-established time.
Hybrid securities: Hybrid securities contain elements of both equity securities and debt securities. One example of a hybrid security is convertible bonds—corporate bonds that can be converted into shares of stock for the issuing company. Another example is preference shares, which are stock shares in a company that entitles the shareholder to receive a fixed dividend before common stock dividends. Preference shares may even grant shareholders voting rights in the company.
Derivative Securities
Derivative securities are financial instruments whose value depends on basic variables. The variables can be assets, such as stocks, bonds, currencies, interest rates, market indices, and goods. The main purpose of using derivatives is to consider and minimize risk. It is achieved by insuring against price movements, creating favorable conditions for speculations and getting access to hard-to-reach assets or markets.
Formerly, derivatives were used to ensure balanced exchange rates for goods traded internationally. International traders needed an accounting system to lock their different national currencies at a specific exchange rate.
There are four main types of derivative securities:
1. Futures
Futures, also called futures contracts, are an agreement between two parties for the purchase and delivery of an asset at an agreed-upon price at a future date. Futures are traded on an exchange, with the contracts already standardized. In a futures transaction, the parties involved must buy or sell the underlying asset.
2. Forwards
Forwards, or forward contracts, are similar to futures, but do not trade on an exchange, only retailing. When creating a forward contract, the buyer and seller must determine the terms, size, and settlement process for the derivative.
Another difference from futures is the risk for both sellers and buyers. The risks arise when one party becomes bankrupt, and the other party may not able to protect its rights and, as a result, loses the value of its position.
3. Options
Options, or options contracts, are similar to a futures contract, as it involves the purchase or sale of an asset between two parties at a predetermined date in the future for a specific price. The key difference between the two types of contracts is that, with an option, the buyer is not required to complete the action of buying or selling.
4. Swaps
Swaps involve the exchange of one kind of cash flow with another. For example, an interest rate swap enables a trader to switch to a variable interest rate loan from a fixed interest rate loan, or vice versa.