There are four main types of security: debt securities, equity securities, derivative securities, and hybrid securities, which are a combination of debt and equity.
Let’s first define security. Security relates to a financial instrument or financial asset that can be traded in the open market, e.g., a stock, bond, options contract, or shares of a mutual fund, etc. All the examples mentioned belong to a particular class or type of security.
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.
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.
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 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 debtholders.
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:
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.
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.
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.
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 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.
Thank you for reading CFI’s guide on Types of Security. To keep advancing your career, the additional CFI resources below will be useful: