Financial securities

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Financial securities, also referred to as financial instruments or financial assets, is a generic term used to describe stocks, bonds, money market securities (e.g., treasury bills), and other instruments representing the right to receive future benefits under a set of stated conditions.[1].

Financial assets are claims on the income generated by real assets (or claims on income from the government). Real assets are the land, buildings, equipment and knowledge used to produce goods and services.[2]

The main purpose of this article is to elucidate, compare, and contrast different ways of classifying financial securities. The sections on individual financial securities consist mainly of links to other Bogleheads Wiki articles on the specific types of securities.

A clear and concise, high-level classification of financial securities is provided by Bodie, Merton (BM). [3] Financial assets are classified as debt, equity, or derivatives. Debt instruments are also called fixed-income instruments. Debt assets with maturities of less than one year are traded in the money market. Long-term debt and equity securities are traded in the capital market. This description is reasonably consistent with the classifications discussed below.

Taxonomy of financial securities

Financial securities can be classified in many different ways. Several "taxonomies" are presented below. Although there are minor differences in terminology and categorization, they generally are in agreement. There is a clear distinction between debt, equity and derivatives, and debt is separated into shorter-term debt securities (generally with maturities of less than one year) and longer-term debt securities.

Bodie, Kane, Marcus (BKM)

Bodie, Kane, Marcus (BKM) present this high-level classification of financial securities: [4]

  • Fixed-income or debt securities
    • Money market securities
    • Capital market fixed-income securities (bonds)
  • Equity securities
    • Common stock
    • Preferred stock
  • Derivative securities

Note that:

  • The three top levels are fixed-income securities, equity securities and derivative securities.
  • Fixed income includes money market securities as well as bonds.
  • Preferred stock is listed as a type of equity.

Elton, Gruber, Brown, Goetzmann (EGBG)

Elton, Gruber, Brown, Goetzmann (EGBG) present this high-level classification of financial securities: [5]

  • Money market instruments
  • Capital market instruments
    • Fixed-income instruments (bonds)
    • Equity instruments (common stock)
    • Preferred stock
    • Mortgage backed securities
  • Derivative instruments

Note that:

  • The three top levels are money market instruments, capital market instruments and derivative instruments.
  • Money market instruments are listed as a distinct category, not as a type of fixed income.
  • Preferred stock is listed as a distinct capital market instrument, not as a type of equity.

BKM vs. EGBG

Although BKM use the term "security" and EGBG use the term "instrument", both sources use the terms interchangeably in their texts.

One difference between the BKM and EGBG classifications, primarily one of terminology, is whether or not fixed-income includes money market securities. BKM classify bonds and money market securities as fixed-income securities. This is useful since the most important asset allocation decision is the ratio of higher-risk assets (stocks) to lower-risk assets (bonds and cash). A secondary asset allocation consideration is the maturity of the debt securities (lower-risk assets), the shortest-maturity securities being money market securities.

Both BKM and EGBG distinguish money market (short-term) debt securities from capital market (long-term) debt securities.

It is clear that both bonds and money market securities are debt securities, so here the term "debt securities" will be used to describe money market securities, bonds, and other fixed-income capital market securities (e.g., mortgage-backed securities).

Although not clear from the classifications shown above, both sources describe preferred stock as a hybrid security. BKM classify preferred stock as an equity, but note that it is similar to both equity and debt. [6]. EGBG classify preferred stock as a distinct capital market instrument, but describe preferred stock (and mortgage-backed securities) as "not so fixed income securities". [7]

BKM by market

BKM also present a more detailed classification of financial securities, broken down by market,:[8]

  • Money market
    • Treasury bills
    • CDs
    • Commercial paper
    • Bankers acceptance
  • Bond market
    • Treasury bonds and notes
    • Federal agency debt
    • Municipal bonds
    • Corporate bonds
    • Mortgage-backed securities
  • Equity markets
    • Common stocks
    • Preferred stocks
  • Derivative markets
    • Options
    • Futures and forwards
    • Swaps

Reilly

Reilly classifies investments by asset class, with more of a focus on investment opportunities for the investor. [9] For example, investment companies (e.g., mutual funds) are broken out into a separate category. Non-financial assets (real assets) also are included.

Financial assets:

  • Fixed-income investments
    • Bank deposit accounts
      • Savings accounts
      • Money market accounts
      • Time deposits (CDs)
    • Capital market instruments
      • U.S. Treasury securities (bills, notes, bonds)
      • U.S. government agency securities
      • Municipal bonds
      • Corporate bonds
      • International bonds
      • Preferred stock
  • Equity instruments (common stocks)
  • Special equity instruments
    • Options
    • Warrants
  • Futures contracts
  • Investment companies (e.g., mutual funds)
    • Money market funds
    • Bond funds
    • Stock funds
    • Balanced funds (stocks and bonds)

Real assets:

  • Real estate
    • REITS
    • Direct real estate investments
  • Low-liquidity investments
    • Antiques
    • Art
    • Coins and stamps
    • Diamonds

Classifying bank deposit accounts as a type of fixed income investment is useful for the individual investor, since FDIC-insured deposit accounts are comparable to money market securities in terms of safety and liquidity, and may provide similar if not higher yields.[10]

Note that Reilly classifies T-bills as capital market securities, whereas the other sources classify them as money market securities. The latter is more common; see for example the Wikipedia articles Capital market and Money market.

Debt securities

Debt securities, sometimes referred to as fixed-income securities, include money market securities and capital market debt securities such as notes, bonds, and mortgage backed securities.

Money market securities

Money market securities are debt securities with maturities of less than one year. Money market securities of most interest to individual investors are treasury bills (T-bills) and certificates of deposit (CDs). See the linked articles for details.

Capital market debt securities

Capital market debt securities are debt securities with maturities of longer than one year. Examples are notes, bonds, and mortgage-backed securities.

Treasury notes and bonds

Government agency debt

Corporate bonds

Main article: Corporate bonds

Municipal bonds

Main article: Municipal bonds

Mortgage backed securities

Equity securities

Equity is another word for "stock", and represents an ownership share in a company. Common stock is a type of equity security. As noted in previous sections, preferred stock can be considered either equity or debt, since it has characteristics of both; it is included here as an equity security.

Common stock

Main article: Stock Basics

Preferred stock

Main article: Preferred stock

Derivative securities

Main articles: Derivative and Option

Notes

  1. Elton et al, 2003, p. 11
  2. Bodie et al, 2008, p.3
  3. Bodie, Merton, 2000, p. 35
  4. Bodie et al, 2008, p. 5
  5. Elton et al, 2003, p. 12
  6. Bodie et al, 2008, p.39
  7. Elton et al, 2003, p. 16
  8. Bodie et al, 2008, p. 25
  9. Reilly, 1994, pp. 52-65
  10. The terminology used here is slightly modified, based on developments since the text was written, but the basic classification is the same.

See also

References

  • Bodie, Merton (2000). Finance. Prentice-Hall. ISBN 978-0133108972
  • Zvi Bodie, Alex Kane, Alan J. Marcus (2008). Essentials of Investments. McGraw-Hill. ISBN 978-0071263245
  • Elton, Gruber, Brown, Goetzmann (2003). Modern Portfolio Theory and Investment Analysis. Wiley. ISBN 978-0471238546
  • Frank K. Reilly (1994). Investment Analysis and Portoflio Management. The Dryden Press, Harcourt Brace College Publishers, Fourth Edition. ISBN 978-0030970528