What is a Security?

Key takeaways

• A security is a certificate which proves that the holder has a particular right, such as ownership or creditor's rights.

• In some cases, securities allocate capital more efficiently by connecting investors to those who demand financing.

• There are four types of securities: equity, debt, hybrid, and derivative securities.

• Securities have different risk, profitability, and liquidity profiles. It's almost impossible to find one with low risk, high profitability, and good liquidity at the same time. Moreover, many securities have maturity dates.

Understanding a security

In the 17th century Netherlands, the East India Company raised money from the public and engaged in voyages, which generated huge profits. In the form of notes, which are considered the predecessor of securities, it promised to pay dividends to investors.

In short, a security is a certificate that proves that the holder has a particular right, such as ownership or creditor's rights. Over time, securities have gradually become paperless.

To be more precise, when we say financial securities, we actually refer to securities that can be seen as financial assets or instruments. They have values and prices. They can be traded and can generate income for their holders.

Stocks are a type of security that easily pops into our mind, but there are other examples like bonds, mutual funds, options, and so on.

What can securities do? Governments or companies use securities to raise capital, for example, issuing bonds or through IPOs. Investors trade securities to make a profit.

Based on this situation, securities can allocate social capital more efficiently by connecting investors to those who demand financing.

Financial activities related to securities are regulated by the securities regulatory agency. In the U.S., the agency is called the Securities and Exchange Commission (SEC). In addition, there are some self-regulatory organizations to help coordinate securities-related activities.

Types

There are four types of securities.

1. Equity securities

A stock is a typical example of equity securities. An equity security provides the holder with a proportion of ownership of a company.

Holders may get dividends at certain times. When they sell a security at a higher price than what they paid, they can also get capital gains.

An equity security rises and falls in value according to many complex factors. So, on the one hand, holders may get returns from the company's growth. But on the other hand, they face high risks also.

2. Debt securities

Corporate bonds, government bonds, and certificates of deposit are all debt securities.

When you buy a debt security, it means that you lend a certain amount of money to the security issuer, which can be a bank, a company, or a government.

The issuer usually should give you a regular interest payment at a pre-determined rate and repay you the principal amount of money on the maturity date. But some particular securities like zero-coupon bonds don't work that way.

It seems that debt securities are safer than equity securities, but we shouldn't ignore the risks, for example, default, which means the issuer fails to repay principal or interest.

3. Hybrid securities

Some securities combine the characteristics of both equity and debt securities. We can call them hybrid securities.

Hybrid securities include convertible bonds which can be converted into common shares and preferred shares whose payments of capital returns will be prioritized over ordinary shares.

4. Derivative securities

The value of a derivative is based on its underlying assets. Futures, forwards, options, and swaps all belong to this category.

For example, an option gives its buyer the right to buy or sell a specified quantity of assets at a pre-agreed price in a given time frame.

Investors usually use derivative securities to speculate or hedge against risks.

Characteristics

There are four main characteristics of securities.

1. Risk

All securities have risks. Different securities have different levels of risk.

2. Profitability

Investors usually can profit from securities. But since risks are involved, returns are not guaranteed. Risks are related to returns. The higher the returns may be, the greater the risks will be. But don't jump to the conclusion that securities with high risks will certainly lead to high returns.

3. Liquidity

It means the ease at which a security can be traded. It's almost impossible to find a security that has low risk, high profitability, and good liquidity at the same time.

4. Maturity

Maturity means the date on which the life of a security ends. Many securities have certain maturities.