Guide to Securities: 4 Types of Financial Securities

A security is a financial instrument that can be traded in a financial market. The term “security” applies to types of investments that are fungible and negotiable, such as mutual funds, bonds, stocks, stock options, and exchange-traded funds (ETFs). Instead of taking out a bank loan, corporations and municipalities can generate new capital by selling securities. Corporations can raise funds by declaring an initial public offering (IPO) to start selling stock shares on the open market, while state and local governments can sell municipal bonds to generate money to pay for large capital projects, such as building roads, schools, and hospitals. The seller of a security is called the issuer, while the buyer is called an investor.

An initial public offering (IPO) is a limited sale of shares in a company that is transitioning from private ownership to public ownership. Institutional investors (such as pension funds and mutual funds) tend to buy the bulk of IPO shares, but public investors also buy shares during the IPO stage.

Some time after the IPO process concludes, the company begins its first day of trading on public exchanges such as the New York Stock Exchange and NASDAQ. From this point onward, the company's stock is on the open market, available to anyone from exchange-traded funds (ETFs) to Wall Street hedge funds to individual private investors who purchase shares through a brokerage.

Investors can purchase publicly traded securities on stock exchanges, such as the NASDAQ and New York Stock Exchange. If a stock isn't listed on one of the main stock exchanges, investors can also purchase securities directly from the issuer, which is called over-the-counter trading. In the U.S., it's the job of the U.S. Securities and Exchange Commission to regulate the securities market and protect investors against stock market manipulation.

After a company's initial public offering (IPO), investors can buy and sell the securities on the secondary market. The secondary market means that new investors can only purchase securities from current shareholders. When current shareholders sell their securities, they're selling to other investors, ideally for capital gain, meaning they sell their securities for more than they initially bought them for.

There are four primary types of securities:

1. 1. 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.
2. 2. Debt securities: Debt securities, also called fixed-income securities, allow governments and corporations to raise money through publicly-traded loans in exchange for regular payments of interest plus the repayment of the principal loan. With debt securities, the investor is the lender and the issuer is the borrower. An investor purchasing debt security receives interest payments from the issuer until the loan reaches its maturity date. At that time, the issuer then repays their initial debt obligation, known as the principal balance. Examples of common debt securities include certificates of deposit (CDs), corporate bonds, and government bonds, which include municipal bonds and treasury bonds. Government bonds typically have a lower interest rate than corporate bonds but have high liquidity, which makes it easy for the investor to potentially resell on the secondary bond market.
3. 3. 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.
4. 4. Derivatives: The value of a derivative security depends on the value of another underlying asset (e.g., a barrel of oil). With derivative securities, both parties involved in the contract are essentially betting on the underlying asset's value changing in opposite ways. Examples of common derivative securities include futures, forwards, swaps, and options. Self-regulatory organizations, like the Financial Industry Regulatory Authority (FINRA), help regulate derivative securities.

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