What are the main types of financial securities?

By financial securities, or financial assets, we mean legally binding contracts which give their owners the right to receive future payments under specified conditions. The type of payments and the conditions for the payments could vary greatly. And this is what distinguishes the different securities. There are many different ways of classifying financial securities. One possible classification is based on whether they are debt or equity securities. Another distinction is whether they are direct investment or an indirect investment.

In general terms, debt involves a party borrowing money from another party. We thus have a borrower and a lender. Debt securities entitle their owners to receive a flow of payments which usually include interest and the repayment of the principal on the loan. Common debt instruments are bonds. Interest is paid at regular intervals - for instance, annually or twice a year - and interest payments take the form of coupons. Bonds can be issued by government, other public entities such as local authorities, or by private corporations, in which case they are called corporate bonds. By contrast, equity-based securities are claims on the assets of a company. They can be seen as representing ownership of the assets.

The most common form of equity securities are stocks. If you own stocks in a company, you are not usually entitled to a fixed flow of payments, but you can receive dividends paid out by the company. You are typically also able to exercise voting rights and can thus influence the decisions made by the company. Furthermore, the market value of your stocks may go up. In this case, you enjoy capital gains on your investment. On the other hand, the market value of your stocks may go down, in which case you suffer a capital loss.

Bonds are classified as fixed-income securities, because they typically promise a fixed stream of coupon payments. Another type of debt securities are mortgages, when we buy a house or real estate. The value of the real estate is the collateral of the loan. We also have asset-backed securities, or ABS, which consist of a portfolio of debt securities. And these securities could include mortgages, bonds, or other assets. A particular form of asset-backed securities are collateralised debt obligations, or CDOs, where the assets involved are portfolios of bonds issued by governments or by corporations.

Derivative securities or derivatives, as they are known, are financial assets whose value depends on the value of an underlying asset - for instance, a stock or a commodity such as oil or cocoa. We therefore say that the value of a derivative derives from the value of the underlying asset. The most important derivatives are futures and options. And we’ll study futures and options in week 3 of the course.

You make a direct investment when you purchase a certain amount of a given security, such as a stock or a bond. You could instead opt to invest in a mutual fund, which is an indirect investment. A mutual fund bundles together stocks or bonds or other securities and then sells shares in this portfolio of securities. A mutual fund is usually managed by professionals and could include stocks - in which case we say that we have an equity fund - or bonds - in which case we have a fixed-income fund. Mutual funds can help diversify the risk of your investment, because the return is an average of the performance of the individual securities in the fund.