Securities: Definition and Effect on the U.S. Economy

Understand the 3 Types of Securities

Securities
Stocks Close Higher After Fed Chair Yellen Addresses Congress. Photo: Andrew Burton/Getty Images News/Getty Images

Definition: Securities are investments that can be traded on a secondary market. Examples include stocks and bonds. Securities allow you to own the underlying asset without taking possession. 

For this reason, securities are readily traded. That means they’re very liquid. They are easy to price, and so are excellent indicators of the underlying value of the assets. 

Traders must be licensed to buy and sell securities to assure they are trained to follow the laws set by the Securities and Exchange Commission.

The invention of securities helped the create the huge success of the financial markets.

There Are Three Types of Securities

1. Equity securities are shares of a corporation. You can buy stocks of a company through a broker. You can also buy shares of a mutual fund that selects and purchases stocks for you. The secondary market for equity derivatives is the stock market. It includes the New York Stock Exchange,  the NASDAQ and BATS.

An Initial Public Offering is when companies sell stock for the first time. Investment banks, like Goldman Sachs or Morgan Stanley, sell these directly to qualified buyers. That's because it is an expensive investment option. These shares are sold in bulk quantities. Once they 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 price.

2. Debt securities are loans, called bonds, made to a company or a country.

You can buy bonds from a broker. You can also buy mutual funds of selected bonds.

Rating companies evaluate how likely it is the bond will be repaid. These companies include Standard & Poor's, Moody's and Fitch's. To ensure a successful bond sale, borrowers must pay higher interest rates if their rating is below AAA.

If the ratings are very low, they are known as junk bonds. Despite their risk, investors buy junk bonds because they offer the highest interest rates.

Corporate bonds are loans to a company. If the bonds are to a country, they are known as sovereign debt. 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 dropped 200 points. That's how significant Treasury bond rates are to the U.S. economy.

3. Derivative securities are based upon the value of underlying stocks, bonds or other assets. They allow traders to get a higher return than buying the asset itself. 

Stock options allow you to trade in stocks without buying them upfront. For a small fee, you can purchase a call option to buy the stock at a certain date at a certain price. If the stock price goes up, you exercise your option and purchase the stock at your lower negotiated price. You can either hold onto it, or immediately resell it for the higher actual price.

put option gives you the right to sell the stock at on a certain date at an agreed-upon price. If the stock price is lower 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 cost you the fee for the option.

Futures contracts are derivatives based on commodities. The most common are oil, currencies, and agricultural products. Like options, you pay a small fee, called a margin. It gives you the right to buy or sell the commodities for an agreed-upon price in the future. 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 are derivatives whose values are based on the returns from bundles of underlying assets, usually bonds. The most familiar are mortgage-backed securities, which helped create the subprime mortgage crisis. Asset-backed commercial paper are corporate loan bundles. They are backed by assets such as commercial real estate or autos. Collateralized debt obligations take these securities and divide them into tranches, or slices, with similar risk.

Auction-rate securities were derivatives whose values were determined by weekly auctions of corporate bonds. They no longer exist. Investors thought the returns were as safe as the underlying bonds. The securities' returns were set according to weekly or monthly auctions run by broker-dealers. This was a shallow market,meaning not many investors participated. That made the securities more risky than the bonds themselves. The auction-rate securities market froze in 2008. That left many investors holding the bag. It led to SEC investigations.

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 those companies 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 lose their entire life savings. That happened on Black Thursday, leading to the Great Depression of 1929.

Derivatives make this volatility worse. 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, CDOs allowed banks to make more loans. They received money from investors who bought the CDO and took on the risk. 

Unfortunately, all 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 complex that investors bought them without understanding them. When the loans defaulted, panic ensued. Banks realized they couldn't figure out what the derivatives' prices should be. That made them impossible to resell on the secondary market. 

Overnight, the market for them 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. For more, see The Global Financial Crisis of 2008