Financial securities are fungible, negotiable instruments that hold some sort of monetary value. A security can represent ownership in a corporation in the form of stock, a creditor relationship with a governmental body or a corporation represented by owning that entity’s bond, or rights to ownership as represented by an option.
What Are Examples of Securities?
There are different types of financial securities, such as: (1) equity securities; (2) debt securities; (3) hybrid securities; (4) derivative securities; and (5) asset-backed securities.
Equity securities represent ownership interest held by shareholders in an entity (a company, partnership, or trust), realized in the form of shares of capital stock, which includes shares of both common and preferred stock. Holders are not entitled to regular payments, other than dividends, but they are able to profit from capital gains when they sell the securities (assuming they’ve increased in value).
A debt security represents borrowed money that must be repaid, with terms that stipulate the size of the loan, interest rate, and maturity or renewal date. Debt securities include government and corporate bonds, certificates of deposit (CDs), and collateralized securities (such as CDOs and CMOs), generally entitle their holder to the regular payment of interest and repayment of principal (regardless of the issuer’s performance), along with any other stipulated contractual rights (which do not include voting rights).
Hybrid securities combine some of the characteristics of both debt and equity securities. Examples of hybrid securities include equity warrants (options issued by the company itself that give shareholders the right to purchase stock within a certain timeframe and at a specific price), convertible bonds (bonds that can be converted into shares of common stock in the issuing company), and preference shares (company stocks whose payments of interest, dividends, or other returns of capital can be prioritized over those of other stockholders).
A derivative is a type of financial contract whose price is determined by the value of some underlying asset, such as a stock, bond, or commodity. Among the most commonly traded derivatives are call options, which gain value if the underlying asset appreciates, and put options, which gain value when the underlying asset loses value.
An asset-backed security represents a part of a large basket of similar assets, such as loans, leases, credit card debts, mortgages, or anything else that generates income. Over time, the cash flow from these assets is pooled and distributed among the different investors.
How Are Securities Regulated?
Securities are regulated by the U.S. Securities and Exchange Commission (SEC). Within the SEC, there are other governmental bodies that take in regulatory functions, such as Self-Regulatory Organizations (SROs), the National Association of Securities Dealers (NASD), and the Financial Industry Regulatory Authority (FINRA).
What Are Residual Securities?
Residual securities are a form of convertible security; convertible securities can be changed into another form, usually that of common stock. A convertible bond, for example, is a residual security because it allows the bondholder to convert the security into common shares. Preferred stock may also have a convertible feature. Corporations may offer residual securities to attract investment capital when competition for funds is intense.
When a residual security is converted or exercised, it increases the number of current outstanding common shares. This can dilute the total share pool and also their price. Dilution also affects financial analysis metrics, such as earnings per share, because a company’s earnings have to be divided by a greater number of shares.