Equity Securities
Equity securities (stocks) are ownership shares of a corporation.
Stocks
You can buy stocks of a company through a broker. You can also purchase shares of a mutual fund that selects the stocks for you. The secondary market for equity derivatives is the stock market. It includes the New York Stock Exchange, the NASDAQ, and BATS.
Initial Public Offering
An initial public offering (IPO) is when companies sell a stock for the first time. Investment banks, like Goldman Sachs or Morgan Stanley, sell these directly to qualified buyers. IPOs are an expensive investment option. These companies sell them in bulk quantities. Once IPOs hit the stock market, their price typically goes up, but you can’t cash in until a certain amount of time has passed. By then, the stock price might have fallen below the initial offering price.
Debt Securities
The majority of debt securities are loans (called “bonds”) made to a company or a government. You can buy bonds from a broker. You can also purchase mutual funds that are based on selected bonds. Loans to a national government are known as “sovereign debt.”
Corporate Bonds
Corporate bonds are loans to a company. If a corporation’s bonds are rated below AAA, they must pay higher interest rates. If the scores are very low, they are known as “junk bonds.” Despite their risk, investors buy junk bonds because they offer the highest interest rates.
Treasury Bonds
The U.S. government issues Treasury bonds. Because these are the safest bonds, Treasury yields are the benchmark for all other interest rates. In April 2011, when Standard & Poor’s cut its outlook on the U.S. debt, the Dow Jones Industrial Average dropped by 200 points. That’s how significant Treasury bond rates are to the U.S. economy.
Municipal Bonds
Municipal bonds are issued by cities and other local governments. They have traditionally been safe investments, but they are not protected if a city or municipality goes bankrupt.
Derivative Securities
These complex securities are based on the value of underlying stocks, bonds, or other assets. They allow traders to get a higher return for a lower investment than they would by buying the asset itself, but that leverage makes them very risky.
Stock Options
Stock options allow you to trade stocks without buying them upfront. For a small fee, called a premium. you can purchase a call option to buy the stock at a specific date at a certain price. If the stock price goes up, you exercise your option and buy the stock at your lower negotiated price. You can either hold onto it or immediately resell it for the higher actual price. A put option gives you the right to sell the stock on a certain date at an agreed-upon price. If the stock price is lower on that day, you buy it and make a profit by selling it at the agreed-upon, higher price. If the stock price is higher, you don’t exercise the option. It only costs you the fee you spent on the option. With stock and put options, each contract is a bundle of 100 shares. In many cases, the risk can be all of your premium, if not more, if you sell the contracts rather than purchase.
Futures Contracts
Futures contracts are derivatives based primarily on commodities, although they can also include other assets. The most common are oil, currencies, and agricultural products. Like options, you pay a small fee, called a “margin.” The margin is only a small representation of the larger contract purchased. It gives you the right to buy or sell the commodities for an agreed-upon price in the future. Due to more volatility, the futures contract could move against you, resulting in losing more than just your margin deposit. Futures are more dangerous than options, because you must exercise them. You are entering into an actual contract that you have to fulfill.
Asset-Backed Securities
Asset-backed securities are derivatives whose values are based on the returns from bundles of underlying assets, usually bonds. The most well-known are mortgage-backed securities, which helped bring about the subprime mortgage crisis. Less familiar is asset-backed commercial paper. It is a bundle of corporate loans backed by assets such as commercial real estate or cars. Collateralized debt obligations take these securities and divide them into tranches, or slices, with similar risk.
How Securities Affect the Economy
Securities make it easier for those with money to find those who need investment capital. That makes trading easy and available to many investors. Securities make markets more efficient. For example, the stock market makes it easy for investors to see which companies are doing well and which ones are not. Money swiftly goes to businesses that are growing. That rewards performance and provides an incentive for further growth. Securities also create more destructive swings in the business cycle. Since they are so easy to buy, individual investors can purchase them impulsively. Many make decisions without being fully informed or diversified. When stock prices fall, they can lose their entire life savings. That happened on Black Thursday, leading to the Great Depression of 1929. At first, investors thought derivatives made the financial markets less risky. They allowed them to hedge their investments. If they bought stocks, they just purchased options to protect them if the stocks’ prices fell. For example, collateralized debt obligations (CDOs) allowed banks to make more loans. They received money from investors who bought the CDO and took on the risk. Unfortunately, all of these new products created too much liquidity. That created an asset bubble in housing, credit card, and auto debt. It created too much demand and a false sense of security and prosperity. CDOs allowed banks to loosen their lending standards, further encouraging default. These derivatives were so complicated that investors bought them without understanding them. When the loans defaulted, panic ensued. Banks realized that they couldn’t figure out what the derivatives’ prices should be. That made it impossible to resell on the secondary market. Overnight, the market for CDOs disappeared. Banks refused to lend to each other because they were afraid of receiving potentially worthless CDOs in return. As a result, the Federal Reserve had to buy the CDOs to keep global financial markets from collapsing. Derivatives created the global financial crisis of 2008. Because securities are easily traded, many types are highly volatile. Study securities that you wish to risk investing in before adding them to your portfolio.
