Before the electronic era, if you made an investment, you were issued a paper certificate or note of some kind, which served as documentation of your investment and outlined the terms of the investment. These paper certificates were called securities, and they were proof of your investment. Paper securities could be bought and sold, just as we buy and sell stocks or bonds or shares of mutual funds today.
A Security is a Security by Any Other Name
Today, the term security refers to just about any negotiable financial instrument, such as a stock, bond, options contract, or shares of a mutual fund. Consider the term “security,” or “securities,” interchangeable with the word “investment,” and the term “securities market” interchangeable with the work “capital markets” or simply “the market.” Securities fall into three broad categories:
- Debt Securities: also called fixed income securities
- Equity Securities: which refers to common stocks
- Derivative Securities: which refers to various forms of options contracts
Debt Securities, a Fancy Name for Bonds
When a business borrows to grow, first it will borrow using traditional means; the banks. Banks don’t want to take too much risk, so they will only lend so much to any one business. The business then must go to the capital markets and issue a debt security which is called a bond. When you buy a bond, you are lending your money to a company, and they owe it back to you. They must also pay you interest.
Equity Securities, a Fancy Name for Stocks
When a business takes on additional owners to grow, it can either find private investors, or it can go to the capital markets and issue securities in the form of publicly traded stock.
When you buy a stock, you become an owner of the company, and as the company makes a profit, you will participate in that profit in one of two ways. Either the company will pay a dividend, which you will receive, or they will use their profits to grow the business further, and, if all goes well, you should subsequently see your stock rise in value. These stocks and bonds are called securities and makeup what investors call “the market.”
Derivative Securities, a Complicated Form of Investment
With derivative securities, instead of owning something outright, like shares of a stock, you own the right to trade other financial securities at pre-agreed upon terms. Options contracts are a form of a derivative security. They give you the right to buy or sell shares of an existing security at a specific price, by a specified date in the future. You pay for this right, and the price you pay is called the “premium.” Think of it as an insurance premium.
Here’s an example: Let’s say WIDGET stock is trading at $50 a share. You buy an option contract that gives you the right to buy it at $50 a share because you feel sure it is going to $60, but just in case it doesn’t, you don’t want to be out the full cost of $50 a share. Your option costs $1 per share. WIDGET does go to $60, and so you immediately exercise your option and flip the stock, making an instant $9 a share ($10 profit minus the $1 premium cost.)
The Securities Market
Many people entrust their life savings to the securities market without understanding what it is. Naturally, this lack of understanding makes them prone to following bad advice as to when and how to participate in this market.
The securities market is not all that different than the real estate market. Just as the housing market is composed of millions of families who all have a dream of home ownership, the securities market is composed of thousands of business owners who all have a dream of building and growing a successful, thriving business.
Most of these large businesses would never be able to achieve their level of success without borrowing or raising money in some way, just as most of us would not be able to own a home without first taking out a mortgage. Every business idea must get capital from somewhere. Capital is used to build the infrastructure necessary to grow the business.
In rare cases, the business owners have enough money to fund the business themselves. In these cases, the business remains privately owned, and the owners get to keep all the profits. If the business owners don’t have the money they need to expand, they can either borrow it or take on additional owners who do have capital. It is where you, the investors, become involved.
When businesses issue securities in the form of stocks and bonds, investors buy them and thus provide the company that capital it needs. Once these securities have been issued, they can then be traded between investors on the secondary market. In the U.S., the securities market is regulated by the SEC, which is the Securities and Exchange Commission.
How Do Securities Get Issued Through the Capital Markets?
When we say a business must go to the capital markets, what does that mean? It means the business hires an investment banking firm who looks at the financials of the business and the total amount of money the business needs to raise; then advises the business on the best way to raise that money (by issuing stock or bonds) and then helps put together and sell a public offering of the securities whereby the newly issued stocks and bonds (securities) are offered to public investors through a network of brokerage firms.