According to Statista.com, as of May 2020, the market capitalization of Apple and Amazon was $1,285.5 and $1,233.4 billion, respectively. The one thing that's consistent about investments in these companies or the purchase of any stock or another security is that an investment's profitability is affected by market risk.
Unfortunately or fortunately as the case may be, the market or systemic risk of stocks, bonds or other securities is compounded by the investor's financial illiteracy. To make matters worse, according to a 2015 Standard & Poor's Ratings Services Global Financial Literacy Survey reported by the Global Financial Literacy Excellence Center, only 33 percent of adults worldwide are financially literate. So, let's start with the basics.
Defining Financial Instruments
The Financial Accounting Standards Board describes a financial instrument as one of three things: cash; evidence that one has an ownership interest in a company or another entity; or a contract that both imposes a contractual obligation on one entity while conveying to the second entity a right to receive a financial instrument or the ability to exchange one instrument for another.
Financial Instruments and Asset Class
A financial instrument can be classified by an asset class, depending on the nature of the instrument. For instance, if a financial instrument demonstrates the holder's ownership in an entity or rights to an ownership in the entity, that instrument is an equity-based security. Alternatively, if the financial instrument is evidence of a loan that one party extends to the instrument's issuing entity, the instrument is debt-based security. On the other hand, if a financial instrument shares some characteristics of both equity-based and debt-based securities, it's a hybrid security.
A shareholder's monetary interest in an entity is represented by an equity security, in the form of capital stock including shares of common or preferred stock. While shareholders may benefit from the receipt of periodic dividends, their primary opportunity for gain takes the form of capital gains which they receive when equity securities are sold.
Along with an interest in a company's equity, the shareholder may exert some control over the operations of a company on a pro-rata basis via voting rights that are associated with equity securities.
Read More: What Is the Stock Exchange?
A creditor's monetary interest in a company is represented by a debt security, which represents a loan that must be repaid. The security notes the loan's terms, including the loan's amount, the interest rate that's charged on the debt's outstanding balance and its maturity date.
Typically, debt securities are issued for a fixed term and redeemed by the issuer at the end of that term. A debit may be secured, or backed by collateral, or unsecured. For instance, a certificate of deposit (CD) entitles the holder to periodic payments of interest and the repayment of the certificate's principal at the end of the CD's term.
A hybrid security, such as an exchange-traded note, incorporates characteristics of both debt and equity securities. Other hybrid securities include convertible bonds – bonds that may be converted to shares of common stock – and preferred shares, stock for which the payment of interest and dividends takes precedence to that of other shareholders.
Read More: Types of Debt Securities
Exploring Fungible and Tradable Securities
A security is a financial instrument that's both fungible and tradable and which a corporation issues to raise capital. In all cases, each class of financial instruments shares particular characteristics, namely, fungibility and tradability.
Securities, such as common stock, are fungible. This means, for example, that one share of common stock issued by a particular company is interchangeable with any other share issued by the same company.
Fungibility implies that the assets that might be exchanged and have equal financial value. Consequently, the fungible nature of securities facilitates the trading of the securities through stock exchanges.
Tradability of Securities
According to Rule 902(b) of the Securities Act, securities are also tradable, meaning that they are liquid, financial instruments that can be traded on either a national securities exchange or an offshore securities market. What's more, the security trades with sufficient volume and liquidity to ensure an investor can dispose of an entire position – a holding in a security – in less than 30 days at a value set by an exchange.
- Statista.com: The 100 largest companies in the world by market capitalization in 2020
- Global Financial Literacy Excellence Center: S&P Global FinLit Survey
- Standard & Poor's Ratings Services: Financial Literacy Aound the World
- LawInsider.com: Tradable Security
- Columbia.edu: Securities Act, Rule 902 (B)
- TheFreeDictionary.com: Fungible
- FASB.org: Accounting for Financial Instruments
- CFA Institute: Overview of Equity Securities
- LexisNexis.com: Types of Debt Securities
- Corporate Finance Institute: Hybrid Securities
- Morningstar Investing Glossary: Debt Securities
Billie Nordmeyer is an IT consultant of 25 years standing. As a senior technical consultant for SAP America and Deloitte Touche DRT Systems, a business analyst, senior staff, and independent consultant, Billie has worked across the retail, oil and gas, pharmaceutical, aeronautics and banking industries. Billie holds a BSBA accounting, MBA finance, MA international management as well as the Business Analyst and Software Project Management certificates from the Cockrell School of Engineering at the University of Texas at Austin.