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Functions of Securities
Generally, securities represent an investment and a means by which companies and other
commercial enterprises can raise new capital. Companies can generate capital through investors
who purchase securities upon initial issuance. Depending on an institution's market demand or
pricing structure, raising capital through securities can be a preferred alternative to financing
through a bank loan.
On the other hand, purchasing securities with borrowed money, an act known as buying on a
margin, is a popular investment technique. In essence, a company may deliver property rights, in
the form of cash or other securities, either at inception or in default, to pay its debt or other
obligation to another entity. These collateral arrangements have seen growth especially among
institutional investors.
Kinds of Securities
There are many different securities that you can invest your money in. They're usually divided
into two categories debts and equities. A debt security represents money that is borrowed and
must be repaid, with terms that define the amount borrowed, interest rate and maturity/renewal
date. Debt securities include government and corporate bonds, certificates of deposit (CDs),
preferred stock, etc.
Equities represent ownership interest held by shareholders in a corporation, such as a stock.
Unlike holders of debt securities who generally receive only interest and the repayment of the
principal, holders of equity securities are able to profit from capital gains. Here's a quick
refresher on some of the most popular security investments.
Debt securities
These include debentures, bonds, deposits, notes and commercial paper (in some circumstances).
Debt securities are usually fixed term securities redeemable at the end of the term, they may be
secured or unsecured or protected by collateral. Debt securities may offer some control to
investors if the company is a start-up or an established business undergoing 'restructuring'. In
these cases, if interest payments are missed, the creditors may take control of the company and
liquidate it to recover some of their investment. People favor buying debt securities because of
the usually higher rate of return than bank deposits. However, debt securities issued by a
government (bonds) usually have a lower interest rate than securities issued by commercial
companies.
Equity securities
Common stock is the most popular type of equity security. Investors are called shareholders and
they own a share of the equity interest of capital stock of a company, trust or partnership. It is
like saying someone who invests in equity securities is buying a tiny part of a company (or a
large part, depending on your budget!).
On the plus side, investing in equity securities can gives a shareholder access to profits and
capital gains, something debt securities will not. The holder of debt securities receives only
interest and repayment of principal no matter how well the issuer performs financially. Equity
investment may also offer control of the business of the issuer.
Derivative contracts
A derivative is a security with a price that is dependent upon or derived from one or more
underlying assets. The derivative itself is a contract between two or more parties based upon the
asset or assets. Its value is determined by fluctuations in the underlying asset.
Derivatives either be traded over-the-counter (OTC) or on an exchange. OTC derivatives
constitute the greater proportion of derivatives in existence and are unregulated, whereas
derivatives traded on exchanges are standardized. OTC derivatives generally have
greater risk for the counterparty than do standardized derivatives.
A derivative is perhaps obviously, derived from some other asset, index, event, value or
condition (known as the underlying asset). Rather than trade or exchange the underlying asset,
derivative traders enter into agreements to exchange cash or assets over time based on the
underlying asset. A simple example is a futures contract: an agreement to exchange the
underlying asset at a future date.
Stocks
Stocks are the best known equity security. You're purchasing an ownership interest in a company
when you buy stock. You're entitled to a portion of company profits and sometimes shareholder
voting rights.
Stock prices can fluctuate greatly. Investors try to buy stock when the price is low and sell it
when the price is high. Stock has a higher investment risk than most other securities. There's no
guarantee that you won't lose money. However, stock usually has the potential for the greatest
returns.
Most stock is considered common stock. Preferred stock normally offers dividends but not
voting rights. Common stockholders also have greater potential for higher returns.
Shares
A share is an equity security. Its owner owns one part of the capital of the company which has
issued the shares in question. The shares enable the shareholder the right to take part in the
decision-making in the company. If the latter operates with profit, the owners of shares may
receive dividends. The amount of the dividend is decided upon by the shareholders at a General
Meeting of the Shareholders.
Corporate Bonds
A corporate bond is a debt instrument issued by a company. It's a loan to the company when you
invest in a bond. You're entitled to receive interest each year on the loan until it's paid off.
Bonds are safer and more stable than stocks. You're guaranteed a steady income from bonds.
However, bondholders aren't entitled to dividends or voting rights. In addition, stockholders have
potential for greater returns in the long run.
Government Bonds
Government bonds are issued by the US federal government. The most common are US Treasury
bonds. They're issued to help finance the national debt.
Government bonds have very low investment risk. In fact, they're virtually risk-free since they're
guaranteed by the US government. However, the potential return is lower than stocks and
corporate bonds.
Municipal Bonds
Municipal bonds are debt securities from states and local government entities. These local
entities include counties, cities, towns and school districts. The interest income you earn on the
municipal bonds is usually exempt from federal income taxes. It may also be exempt from state
and local income taxes if you live where the bonds are issued. However, the interest rate is
usually lower than corporate bonds.
Open-end funds
An open-end fund stands for a diversified portfolio of securities and similar investments, chosen
and professionally managed by a fund management company. Since the fund does not have fixed
capital but is rather 'open ended', it grows together with new investors joining and thus funding
it. Open-end funds can invest in domestic and international securities, in either shares, bonds or
other investment vehicles. Depending on the portfolio, the fund's risk and returns vary
accordingly.
Mutual Funds
A mutual fund is made up of a variety of securities. It may focus on stocks, bonds or a collection
of both. Your money is usually pooled with other investors. An investment company chooses the
securities and manages the mutual fund. This diversity helps decrease investment risk.
Stock Options
A stock option is the right to buy or sell a stock at a certain price for a period of time. A call is
the right to buy the stock. A put is the right to sell the stock. Stock options can be used to help
reduce your investment risk.
Futures Options
A futures contract is an agreement to sell a specific commodity at a future date for an agreed
upon price. A futures option is the right to buy or sell a futures contract at a certain price for a
specific period of time. Many investors use futures options to help reduce investment risk.
Investment certificates
Investment certificates are debt securities issued by a bank, and are designed to offer the investor
an agreed yield under pre-defined conditions stipulated in the prospectus. Issuers are mainly
large banks, and an important criterion in selecting the bank in whose investment certificates you
would like to invest is its credit rating. Investment certificates represent an investment directly
linked to an index, share price, raw material price, exchange rate, interest, industry, and other
publicly available values. The holder of an investment certificate does thereby not become an
indirect owner of the assets underlying the certificate.
A certificate ensures the investor a guaranteed manner of payment. Investment certificates are
predictable and the investor can always anticipate their yield (or loss) in a specific situation,
which makes them a successful investment vehicle in times of heavy market losses. There are
different types of investment certificates some guarantee yields no matter what the situation on
the market, while others yield profit only when the prices fall, etc.
Warrants
Warrants are options issued by a joint-stock company, which give holders the right to purchase a
certain quantity of the respective companys shares at a pre-determined price. After a certain
period, the right to purchase shares terminates.
Securities Market
a) Primary and secondary market
Public securities markets are either primary or secondary markets. In the primary market, the
money for the securities is received by the issuer of the securities from investors, typically in
an initial public offering (IPO). The primary market is concerned with the floatation of new
issues of shares or bonds. The firms floating new issues to raise funds may be new companies or
existing companies planning expansions. The Merchant Banking Division of a commercial bank
is asked by the company to advice on the viability of floatation of an issue before an issue is
actually floated in the market.
In the secondary market, the securities are simply assets held by one investor selling them to
another investor, with the money going from one investor to the other. This market provides both
liquidity and marketability to such securities. It implies that it is a market where a security can be
bought or sold at small transaction cost. Although the Secondary Market deals with the purchase
and sale of old securities, the firms issuing new securities get themselves registered on a Stock
Exchange by applying for listing of shares.
c) Over-the-Counter Markets
An over-the-counter (OTC) market allows investors to trade securities without using organized
stock exchanges. The trades are made by telephone or over an electronic network. There's no
physical location.
An OTC market is considered a dealer negotiated market. Brokers and dealers negotiate among
themselves on prices for securities. The largest electronic network for the OTC market is called
the National Association of Securities Dealers Automated Quotation System (Nasdaq).