SECURITIES

 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

Debt Securities

Debt securities, or fixed-income securities, represent money that is

borrowed and must be repaid with terms outlining the amount of the
borrowed funds, interest rate, and maturity date. In other words, debt
securities are debt instruments, such as bonds (e.g., a government or
municipal bond) or a certificate of deposit (CD) that can be traded
between parties.

(A certificate of deposit (CD) is a savings product that earns interest

on a lump sum for a fixed period of time)

Debt securities, such as bonds and certificates of deposit, as a rule,

require the holder to make the regular interest payments, as well as
repayment of the principal amount alongside any other stipulated
contractual rights. Such securities are usually issued for a fixed term,
and, in the end, the issuer redeems them.

A debt security’s interest rate on a debt security is determined based on

a borrower’s credit history, track record, and solvency – the ability to
repay the loan in the future. The higher the risk of the borrower’s
default on the loan, the higher the interest rate a lender would require
to compensate for the amount of risk taken.

It is important to mention that the dollar value of the daily trading

volume of debt securities is significantly larger than stocks. The reason
is that debt securities are largely held by institutional investors,
alongside governments and not-for-profit organizations.

Equity Securities

Equity securities represent ownership interest held by shareholders in

a company. In other words, it is an investment in an organization’s
equity stock to become a shareholder of the organization.

The difference between holders of equity securities and holders of debt

securities is that the former is not entitled to a regular payment, but they
can profit from capital gains by selling the stocks. Another difference
is that equity securities provide ownership rights to the holder so that
he becomes one of the owners of the company, owning a stake
proportionate to the number of acquired shares.

In the event a business faces bankruptcy, the equity holders can only
share the residual interest that remains after all obligations have been
paid out to debt security holders. Companies regularly distribute
dividends to shareholders sharing the earned profits coming from the
core business operations, whereas it is not the case for the debt holders.

Derivative Securities

A derivative security is a financial instrument whose value depends

upon the value of another asset. The main types of derivatives are
futures, forwards, options, and swaps. An example of a derivative
security is a convertible bond.
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.

Options are financial derivatives that give buyers the right, but not the
obligation, to buy or sell an underlying asset at an agreed-upon price
and date.

TYPES OF OPTIONS

Calls

A call option gives the holder the right, but not the obligation, to buy
the underlying security at the strike price on or before expiration. A
call option will therefore become more valuable as the underlying
security rises in price (calls have a positive delta).

A long call can be used to speculate on the price of the underlying

rising, since it has unlimited upside potential but the maximum loss is
the premium (price) paid for the option.

Puts

Opposite to call options, a put gives the holder the right, but not the
obligation, to instead sell the underlying stock at the strike price on or
before expiration. A long put, therefore, is a short position in the
underlying security, since the put gains value as the underlying's price
falls (they have a negative delta). Protective puts can be purchased as
a sort of insurance, providing a price floor for investors to hedge their
positions.
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.

Hybrid Securities

Hybrid security, as the name suggests, is a type of security that

combines characteristics of both debt and equity securities. Many
banks and organizations turn to hybrid securities to borrow money from
investors.

Similar to bonds, they typically promise to pay a higher interest at a

fixed or floating rate until a certain time in the future. Unlike a bond,
the number and timing of interest payments are not guaranteed. They
can even be converted into shares, or an investment can be terminated
at any time.

Examples of hybrid securities are preferred stocks that enable the

holder to receive dividends prior to the holders of common stock,
convertible bonds that can be converted into a known amount of equity
stocks during the life of the bond or at maturity date, depending on the
terms of the contract, etc.

Hybrid securities are complex products. Even experienced investors

may struggle to understand and evaluate the risks involved in trading
them. Institutional investors sometimes fail at understanding the terms
of the deal they enter into while buying hybrid security.

An option is a derivative, a contract that gives the buyer the right, but
not the obligation, to buy or sell the underlying asset by a certain date
(expiration date) at a specified price (strike price). There are two types
of options: calls and puts. American-style options can be exercised at
any time prior to their expiration. European-style options can only be
exercised on the expiration date.