Security: What is it?

Patrick Curtis

Reviewed by

Patrick Curtis WSO Editorial Board

Expertise: Investment Banking | Private Equity

A security is a financial instrument that holds some value that can be expressed in monetary terms. This value may arise from representing ownership (common stock), the right to ownership (options) or debt owed (bonds).

Security

Generally, they can be traded for the value they represent. Hence, any financial asset is a security.

Some examples are:

  • Stocks
  • Bonds
  • Derivatives
  • Swaps

The legal definition of a security varies based on jurisdiction. For example, in the United States, it means any tradable financial instrument whereas, in the United Kingdom, it means instruments specifically mentioned by the FCA handbook definition.

In earlier times, it used to be represented by means of a physical certificate. However, with the increasing use of technology in the financial sector, this has now become an almost obsolete practice, with most publicly traded securities being issued via electronic (dematerialized) means.

New York Stock Exchange

The trading and exchange of securities among the general public are strictly regulated by the regulatory authorities of the country in which they are traded. As time passes, an increasing number of assets and asset classes are introduced into its definition, so as to increase the coverage of such assets in existing laws and regulations.

Types

They can be classified into 4 types based on their payoff and risk-return characteristics.

Equity Securities

These represent an ownership interest in the equity share capital of a company, trust, or partnership. Since they represent a part of asset ownership, they have the following characteristics:

  • Having rights to the share of profit & loss and net assets of the company means that there are no guaranteed regular payments to equity holders.
  • In case the assets are sold, or the company is shut down, equity holders are paid at the end, after fulfilling the debt holders and preference share claims. This payment may be less than what was paid for acquiring the shares in the first place. Hence, equity holders have a residual claim over the assets of the company.
  • In return for the above risks, equity holders have a say in how the business is operated by virtue of voting rights. They control the management of the business and by extension its profitability.

Corporates

Debt securities

These represents the amount of money the holder has lent to the issuer of the security.

They are classified based on characteristics such as the issuer, maturity, interest rate (IR), collateral, and seniority of the security. A few examples of the same are:

  • Zero-coupon bonds: These bonds do not pay any interest component and are issued at less than par to make up for the lack of fixed interest payments.
  • Corporate bonds: These are issued by industrial and commercial entities.
  • Government bonds: These are issued by sovereign governments or their agencies.
  • Supranational bonds: These are issued by international organizations such as the World Bank and the International Monetary Fund (IMF).
  • Money market instruments: These are short-term debt instruments that are highly liquid and provide a rate of return. Due to their high liquidity, they are considered "cash equivalents" or "near cash".

Since they represent a loan extended to the issuer, they have the following characteristics:

  • Debt holders are entitled to receive the principal (face value) on maturity as well as fixed or variable regular payout based on the face value of the instrument over the maturity horizon. This represents the rate of borrowing (interest rate) for the issuer. An exception to this is zero-coupon bonds which do not pay any fixed interest.
  • In case the underlying business is liquidated, debt holders are paid before equity holders. Further, the order of payment among various classes of debt holders is determined based on the level of collateralization and seniority.
  • As there is no ownership interest and significantly less risk to debt holders, they do not share the same right of control over the issuers.

Trading

Derivative securities

These are different from equities and bonds as they derive their value from an underlying asset, which in turn may be equity, debt, commodities, currencies, alternative assets, or another derivative. As derivatives have very low outlay costs, they provide a source of easy and high leverage.

Derivatives are mainly used by institutional investors to manage risk or maintain high leverage on their portfolios. They are also used to speculate on the market movements.

Hybrid securities

These are a combination of the characteristics of the above types. Some examples are illustrated below.

  • Equity warrants: These are option-like instruments issued by a company that allows its holders to purchase a specific number of shares at a predetermined price within a predetermined period. On exercise of these warrants, new shares are issued by the company in exchange for cash, which dilutes the existing shares.
  • Preferred stock: These are instruments that have characteristics of both equity and debt instruments. Their holders are entitled to regular payments which are like the payment of interest but their claims on the assets are subordinated to the debt holders' and senior to the equity holders' claims. Sometimes, they also entitle its holders to limited voting rights based on the jurisdiction of its issuance.

Examples

How are they traded?

Publicly traded instruments are listed on exchanges for trading. Exchanges provide a liquid and regulated market to the investors in return for a small fee. The ones that are not traded publicly, such as forward contracts and swaps, are traded on over-the-counter (OTC) markets or directly among investors.

To make them available for the public, the issuer must first conduct an initial public offering (IPO). Once the IPO has concluded and shares issued to the subscribers, the shareholders can simply transfer ownership of the shares to other investors for consideration. Another way of allocating shares is by private placement to qualified investors as opposed to an IPO. Most of the offerings today are a combination of an IPO and private placement.

Invest

How to invest in securities?

Investors can buy them at two points, i.e., on the first issue and anytime subsequently.

To invest in them at the time of issue, an investor can subscribe to an IPO if the offer is for public or bid in private markets in case the issuer has decided to issue the said instruments through private placement.

Post the issuing stage, the investor must first find the market or broker with whom the it is available for trading. This could be anything from a stock exchange for publicly-traded instruments to an investment bank for privately-held ones. In the case of publicly-traded instruments listed on an exchange, investing can be as simple as placing a buy order with the exchange, while for private ones the process is longer, as the current holders need to be tracked down and an offer must be made to them for purchase.

Examples of securities available to the public:

Instruments that are available to the general public are usually traded over exchanges of which some examples are:

Patrick Curtis is a member of WSO Editorial Board which helps ensure the accuracy of content across top articles on Wall Street Oasis. He has experience in investment banking at Rothschild and private equity at Tailwind Capital along with an MBA from the Wharton School of Business. He is also the founder and current CEO of Wall Street Oasis This content was originally created by member WallStreetOasis.com and has evolved with the help of our mentors.