Securitization is a complex topic that can be intimidating for those who are new to it. We'll walk through the different types of securities and how they work together to create one entity (i.e., a pool) that holds all these pieces together under one umbrella. For a more in-depth explanation of this post, read on here.
What is security?
The first thing to understand about securitization is the concept of "security." A security is any contract or instrument that represents financial value. Securities can get divided into several types of categories: debt, equity, and derivatives. Debt instruments are the most common types of securities that we'll discuss in this article.
A debt instrument is a contract between two parties. The first party (the borrower) agrees to engage in some financial transaction with the second party (the lender). In return for engaging in the transaction, the borrower pays back a sum of money to the lender. The borrower's promise of payment is a debt instrument because it represents a financial obligation to the lender.
Types of Debt Instruments:
- Loans: Loans are one of the most common types of debt instruments. When an individual or business takes out a loan, they are borrowing money from a lender. The person or company agrees to repay the loan amount, plus interest, by a specific date.
- Debentures: A debenture is a debt instrument that represents ownership in a corporation. A debenture issuer (the borrower) borrows money from an investor (the lender). In return for the money, debenture holders (the debenture holders) receive a contract representing their ownership in the issuer.
- Bonds: Bonds are debentures that an organization has issued (i.e., a corporation or government) instead of by an individual or business.
- Preferred Stock: This type of security represents ownership in a corporation and does not include any obligation for dividend payments, unlike common stock.
- Mortgages: When you take out a mortgage, you borrow money from a bank to purchase a house. In return for the loan, you agree to repay the bank.
Types of Equity Securities
- Common Stock: This security represents ownership in a corporation and includes the right to vote on major company decisions.
- Preferred Stock: It is similar to common stock. However, preferred stock includes the right to receive dividend payments, in addition to voting rights.
- Warrants: It is a security that gives the holder the right, not the obligation, to purchase another security (like common stock or preferred stock) at a pre-determined price.
- Stock Options: It is a contract between two parties where one party has the right to buy another security at a pre-determined price.
- Convertibles: Convertible security, the holder has the right to convert the contract into another type of security, usually common stock in another company.
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