Financial Securities – Definition
A financial security is a document of a certain monetary value. Traditionally, it used to be a physical certificate but nowadays, it is more commonly electronic. It shows that one owns a part of a publicly-traded corporation or is owed a part of a debt issue. In the most common parlance, financial securities refer to stocks and bonds which are negotiable. Derivatives are also considered as a common type of financial security, with its growing popularity in recent years. In current usage, financial securities are no longer an evidence of ownership. Rather, they refer to the financial product themselves i.e. stock, bond, or other product of investment. They are also known as financial instruments or financial assets.
Features of Financial Securities
One of the most important features of financial securities is that they are trade-able i.e. one can convert them into cash quite easily. Holding a financial security gives a right to the holder to receive future monetary benefits under a stated set of conditions. Except for derivatives, securities let you own the underlying asset without taking physical possession. The price of the securities indicates the value of an underlying asset. More the price, higher is the value of the asset.
Types of Financial Securities
We can broadly categorize financial securities into three categories, equity securities, debt securities, and derivative securities. Let us understand them in more detail –
An equity security is a share of interest in the capital of a company, firm or partnership. One can hold an equity interest in other forms of the organization too, other than the ones mentioned above. Holding an equity interest means contributing to the capital of the company. You can do this by buying shares of a company of your choice. A share of a company represents a monetary value. This monetary value is the amount of capital you contribute to the company.
For example, a company ABC plc wants to raise capital. It issues shares 100,000 shares of $10 each. By buying one share of ABC plc, you contribute $10 to its capital. More shares you buy, higher is your contribution to the company’s capital. Since equity shareholders contribute to raising capital of a company, they become owners of the company. Thus, a share represents the value of ownership in a company.
Like owners, equity shareholders have certain rights and duties. They are entitled to the profits of the company. Also, they can also participate in the operations of the company by exercising their voting rights. However, in case a company is incurring losses, equity shareholders get no return. In case of bankruptcy, they are on the losing end. They get paid for their contribution only after all obligations have been discharged. Sometimes, they may not get anything in return on their investment.
Debt securities are essentially loans made to a company. As the name suggests, these securities represent a debt owed by a company to lenders. There are different types of debt securities such as bonds, debentures, commercial paper, etc. These securities are different from each other in terms of maturity, collateral, and other characteristics. They are different from equity securities in the sense that debenture holders are creditors of the company. This is unlike equity shareholders, who are owners of the company.
Debentures or corporate bonds are issued for a fixed period, like any other debt. They have a long maturity as compared to notes that have a shorter maturity. A company may require taking loans from the market for various reasons. In return, creditors earn interest on their loans until the expiry of the term.
For example, ABC plc wants to purchase a commercial property. Due to the entire capital invested in business operations, the company decides to raise a loan from the market. For this, they issue debentures with the face value of $5,000,000 payable after 10 years at 8%. In this way, ABC is able to raise funds for meeting its expenses. However, they would have to pay a yearly interest of $400,000 (8% * $5,000,000). Interest payments are charged to the Profit and Loss account of the company. ABC will have to repay the principal in full post 10 years.
Like equity shareholders, debenture holders too, have certain rights. They are entitled to interest for the amount lent and repayment of entire principal at the time of maturity. Note that c company is liable to make such interest payments even if it is not making adequate profits or incurring losses. In case of winding up of the company, holders of debt securities have an edge over common stockholders. Before the proceeds of the company go to ordinary shareholders, debenture holders get their share. This makes debt securities safer than equity securities. However, their returns are also limited to fixed interest payments only. They do not get any share in the profits of the company.
Derivative securities are those securities whose value is derived from an underlying asset. These underlying assets can be bonds, stocks, commodities, currencies or other assets. These securities trade on exchanges like other financial securities and their value differ with a change in the value of an underlying asset. They themselves have no value of their own. One must note that ownership of a derivative does not mean ownership of an asset. Derivative securities are more sophisticated as compared to equity and debt securities. They work in a very different manner and therefore require sound financial knowledge to mitigate risk and earn good returns.
Derivative securities are also known as derivatives. Their most common use is containing risk. Such risks can be currency fluctuation risks, movements in index or commodities prices, adverse changes in rates of interest, weather, etc to name a few. There are several types of derivatives available in the market, in accordance with the needs of the customers. Broadly, derivatives can be classified as Futures, Forwards, Swaps, and Options.
From the point of view of investment, all financial securities have their own pros and cons. All types of financial securities provide a return commensurate with the risk. However, financial experts are of the opinion that a well-diversified portfolio is a key. Investing in different types of securities ensures that returns are stable.