What are securities? A Guide to How Securities Work

What are Securities

Security refers to any financial instrument or asset that can be traded. Investopedia defines securities as a fungible, negotiable financial instrument that holds some type of monetary value. An important thing you should know about securities is that the nature of what can or cannot be termed as a security generally depends on the jurisdiction from which the instruments are being traded.

Some of the most famous examples of securities are the following;

·       Stocks

·       Bonds

·       Exchange-Traded Fund shares

·       Mutual fund shares

Characteristics of Securities

Securities have specific characteristics that make them qualify as securities. The following are some of the features of securities that you should know about.

1.      Securities are Fungible

The first essential characteristic of securities is that they are fungible. It means that a security can be exchanged quickly and easily by other securities. For instance, one company's shares can be replaced easily and quickly by the other shares of the same company stocks.

2.      Regulation of Securities

A regulatory body governs securities. For instance, in the United States, the Securities and Exchange Commission is mandated in the regulation of securities.

3.      Legal Definition Based on Jurisdiction

Another important thing you must know about securities is that they do not have a universal definition. The definition of securities will vary between different countries and jurisdictions.

4.      Categories of Securities

Another thing we should talk about when looking at the characteristics of securities is to check out the different types of securities. There are four types of securities, namely;

·       Debt securities

·       Derivatives

·       Equity securities

·       Hybrid securities

In the following segment, we will discuss further details about different types of securities and how they work.

Types of Securities

1.      Equity Securities

Equity security refers to the shares of stock that shareholders have taken up in a company. Shareholders can exist in the form of individuals, a trust, a partnership, or a company.

Equity securities holders are not entitled to regular earnings. However, equity securities pay out regular dividends to the shareholders. Dividends are the share of profits earned by the company, which are paid to shareholders. Shareholders can receive dividends in the form of cash or property. Upon receiving the dividends, shareholders can either use them or plow them back to increase their equities.

Equity securities are significant because they give the shareholders some degree of ownership of the company. Essentially, the contributed equity is the capital that runs the company's operation, which is why the shareholders are given the degree of control, but on a pro-rata basis. The shareholders usually have the voting rights they exercise to elect board members and vote over pertinent corporate issues.

If the company goes bankrupt, the equity securities shareholders will only share the residual interest, which is the interest that remains after all the other obligations have been dealt with, For instance, payment of creditors and suppliers. They might also be offered as a payment-in-kind. Payment-in-kind is where goods or services are used to meet payments obligations and not cash.  

2.      Debt Securities

Debt security refers to the share of money borrowed, which must be paid. They differ from equity securities because they involve borrowed money and the selling of a security. Debt security usually comes with terms that stipulate the size of the loan, the interest rates charged, and the maturity period. Popular debt securities include corporate bonds, banknotes (promissory notes), certificates of deposits, and collateralized securities.

Debt securities generally entitle their holders to the regular interest payments and principal as well as any other contractual rights that will be stipulated. Debt security holders do not have voting rights. They are issued for a fixed period and are also redeemable at the end of the said period.

3.      Derivatives

Derivatives are unique securities. They differ from other securities greatly because their worth is based on an underlying asset, which must be bought and repaid at a specified price, interest, and maturity date specified during the initial transaction.

The person selling the derivative does not have to have ownership of the underlying asset outright. All required is for the seller to pay the buyer back when there is enough cash to buy the underlying asset. But where do derivatives derive their value?

Derivatives often derive their value from the commodities like precious metals such as gold, silver, and diamond. Other commodities such as gas and fuel can also apply. Other underlying assets that a derivative can be structured include currencies, prevailing interest rates, treasury bonds, treasury bills, and stock prices.

To offset risks from other investments, derivatives are usually traded with hedge funds. As I already mentioned, a seller does not have to have ownership of the underlying asset. All it might take is a small down payment. This makes derivatives excellent security to trade in.

4.      Hybrid Securities

Hybrid securities combine the characteristics of debt security and equity securities. Some of the famous examples of hybrid securities are equity warrants, preference shares, and convertible bonds. Equity warrants are the options that the company issues, giving the shareholders the ability to buy stocks at a specified price and within a specific time frame.

Convertible bonds can be converted into shares of the common stock in an issuing company. Preference shares are shares that are regarded with much more priority than other shares. The interests and dividends accrued by preference shareholders must be paid first before all others.

How Do Securities Work?

All the publicly traded securities are usually listed on the stock exchanges market. Issuers must maintain a liquid and properly regulated stock market to attract investors. Whereas long ago, people relied on informal trading systems; the case is now different as most people rely on the electronic trading system to trade in stocks. Securities are now easily traded online using a mobile phone or a computer device.

The first major sale of equity securities by a company is referred to as the Initial Public Offering (IPO). After the Initial Public Offering, any newly issued stocks sold in the primary market are referred to as the secondary offering.

Moreover, securities can also be traded privately by a restricted and qualified group. The process of trading securities privately is referred to as private placement. In most cases, most companies will offer their stocks both publicly and privately.

In the aftermarket, a term used to refer to the secondary market, securities are transferred as assets from one shareholder to another. The secondary market, therefore, exists as a complement to the primary market. It is also less liquid than the primary market because securities are only transferred between qualified investors.  

Factors To Consider When Investing in Securities

The decision to invest in security could be as lucrative as it sounds. However, you are bound to lose your money if you fail to approach it carefully. There are several factors that you must consider when investing in securities. The following are some of the factors;

1.      Returns on Investment

The first important factor that you must consider before investing in securities is the return on investments. ROI is the value you get after deducting all costs on investments. If the investment has low returns, there is no point in working with such an investment. Instead, it would be best if you considered other securities that promise high investments

2.      Risks Involved

You should also choose an investment that has low risks. Risks refer to the possibility of losing money because of unforeseen circumstances. As a rule of thumb, the higher the returns on an investment, the higher the risks. For instance, shares have high risks than a fixed deposit. However, they also have higher returns. It is always essential to evaluate your investment so that you do not make any mistakes.

3.      Investment Period

The investment period has a direct impact on the return on investments. The investment periods can be long, medium, or short.  Short-term investments are those that do not go past one year. Long-term investments will go for long periods of ten or even more years. Long-term investments also earn high returns.

4.      Liquidity

Before investing in any security, ask yourself, "how quickly can I convert the investment returns into cash?" You must always go for more liquid investments.

Other factors that you must consider when investing in securities are the following;

5.      Tax Implications

6.      Prevailing Inflation Rates

7.      Volatility

8.      Budget

Conclusion

Securities are a great way to invest. There are four types of securities that you can invest in. They are hybrid securities, derivatives, debt securities, and equity securities. This article has explained the meaning of securities, how securities work, the types of securities, and some of the factors you must consider when investing in securities. You will find this information valuable, especially when you have been interested in the stock markets.