Types of Securities in Finance
Primarily there are four categories of securities in finance:
Equity – which provides ownership rights to its holders
Debt – essentially loans repaid with periodic payments
Hybrid – combination of equity and debt
Derivative – whose value depends on the basic variables
Equity Securities
Equity securities represent the ownership rights possessed by the shareholders in an organization. Simply put, it is an investment made by the members of the organization to become the company’s shareholder by investing in its equity stock.
When a business suffers bankruptcy, the equity shareholders are only entitled to residual interest that remains after all the obligations have been paid off to debt security holders.
Debt Securities
Debt securities are fixed-income securities that represent the borrowed money. It must be repaid with the terms as regards to the amount of the borrowed funds, maturity date, and interest rate. For instance, debt securities like bonds or a certificate of deposit is tradable between parties.
The interest rate of a debt security is based on the borrowers’ credit history, solvency, and track record. It is also determined by their ability to repay the borrowed funds in the future. Securities are usually issued for a fixed term and are redeemed on maturity.
When there is a higher risk of the borrower’s default on the loan, the interest rate is also higher for the lender to compensate for the amount of risk taken.
Hybrid Securities
Hybrid securities combine the features of both debt and equity features. They pay a predictable rate of return or dividend until a certain date. This date is the one in which the holder can convert the securities into underlying shares.
Hence, unlike equity securities, the holder is entitled to a predetermined cash flow. As well, unlike debt security, the holder has an option to convert the security to the underlying equity. Converting preference shares are the most common example of hybrid securities.
Derivatives
Derivative securities are nothing but simple financial instruments whose value depends on basic variables. These variables can be in the form of stocks, currencies, bonds, market indices, goods, interest rates, etc.
The main objective of using derivatives is to take the risks into consideration and minimize them. It can be achieved by insuring against price movements by giving rise to favourable conditions for speculations.
Derivatives were previously used to ensure balanced exchange rates for goods that were traded on an international level. Hence, international traders were in need of a proper accounting system so as to lock the various national currencies at one uniform exchange rate.
Derivatives are further classified into:
- Futures
- Forwards
- Options
- Swaps
It involves the exchange of one kind of cash flow with another. For instance, an interest rate swap will enable a trading party to switch to a fixed interest rate loan.
You might also be interested in: Marginal Cost of Fund-Based Lending Rate (MCLR) study notes!
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