The main types of financial securities are bonds and equities. Bonds are debt instruments. They are a contract between a borrower and a lender in which the borrower commits to make payments of principal and interest to the lender, on specific dates.
The main types of financial securities are bonds and equities.
Bonds
Bonds are debt instruments. They are a contract between a borrower and a lender in which the borrower commits to make payments of principal and interest to the lender, on specific dates. In return, the lender provides a loan to the borrower. The borrower is the issuer of the bond, and the lender is the bondholder. The interest payments are also known as coupons.
The main components of a bond are:
- Maturity – this is the date when the bond must be repaid
- Principal or face value – this is the amount that will be repaid at maturity (for instance, $1,000)
- Coupon – this is the interest rate paid by the issuer of the bond, applied to the face value.
Bonds are issued by governments (Government or Treasury bonds), local governments (Municipal bonds) and corporations (Corporate bonds).
Bond Market Price
The market price of a bond is computed as the value of the future payments, discounted at an appropriate rate of interest. We discount future payments to account for the time value of money. Time value means we prefer to receive a payment of money sooner rather than later. Discounting also takes into account the opportunity cost of investing in the bond, meaning what we could do with our money if we were not investing in the bond.
For instance, if a bond with a three-year maturity promises to pay a fixed annual coupon of $40 and the principal $1,000, and if the relevant rate of interest for discounting is 5%, the market price of the bond (P) is:
[P={$40over(1+0.05)}+{$40over(1+0.05)^2}+{$40+$1,000over(1+0.05)^3}] [=$38.10+$36.28+$898.39] [=$972.77]
Thus, the value of the bond, ie, its market price, is $972.77. You will notice the interest rate used to discount the bond payments (5% in this case) is not necessarily the same as the interest rate used to calculate the coupon payments (4%). Notice also how payments that will be received further into the future are discounted more than payments that will be received sooner.
Equities
Ordinary shares, or common stock, represent a share of ownership in a corporation. Shareholders are regarded as the owners of the corporation and usually have the right to vote. They are entitled to the residual profits of the company after all other claims are satisfied. Shareholders are also entitled to receive dividends, although companies are usually under no obligation to pay dividends to ordinary shares.
Preferred stock, or preference shares, confer to their holders the right to receive a claim on the firm’s earnings, before dividends on ordinary shares can be paid. Preferred stock is also a senior claim on the firm’s assets in the event of a liquidation of the company. They are therefore a less risky form of investment than common stock.
What do you get if you hold a stock for a period of time? If the stock price goes up over the period you make a capital gain. If the stock price goes down you make a capital loss. And you receive a dividend payment if one is made. If we express these relative to the initial value of the stock, this is known as the total holding period return:
[HPR= frac {Div+(P_1-P_0)}{P_0}]
where (Div) are the dividends paid on the stock, (P_0) is the value of the stock at the start of the period, and (P_1) is the value of the stock at the end of the period. The difference ((P_1-P_0)) is the capital gain on the stock; if it is negative, it is the capital loss.
FAQs
Equities are high-risk investments, thus ideal for investors with high-risk tolerance levels. On the other hand, bonds are comparatively less risky than equities. Therefore, they are suitable for investors with low-risk tolerance levels. This article covers in detail equities vs bonds.
What are stocks and bonds summary? ›
The biggest difference between stocks and bonds is that with stocks, you own a small portion of a company, whereas with bonds, you loan a company or government money. Another difference is how they make money: stocks must grow in resale value, while bonds pay fixed interest over time.
What is the basic understanding of stocks and bonds? ›
A stock is an investment in a company. Your investment (purchased in shares) can grow or decline based on the company's success. A bond is an investment in a company's or government's debt. After you purchase a bond, the entity develops a plan to repay the principal of your investment with interest.
What is a bond explained to me? ›
A bond is a loan that the bond purchaser, or bondholder, makes to the bond issuer. Governments, corporations and municipalities issue bonds when they need capital. An investor who buys a government bond is lending the government money. If an investor buys a corporate bond, the investor is lending the corporation money.
What is better equities or bonds? ›
Stocks offer an opportunity for higher long-term returns compared with bonds but come with greater risk. Bonds are generally more stable than stocks but have provided lower long-term returns.
Are bonds debt or equity? ›
The main types of financial securities are bonds and equities. Bonds are debt instruments. They are a contract between a borrower and a lender in which the borrower commits to make payments of principal and interest to the lender, on specific dates.
What is a bond in easy terms? ›
Bonds are investment securities where an investor lends money to a company or a government for a set period of time, in exchange for regular interest payments. Once the bond reaches maturity, the bond issuer returns the investor's money.
What is the difference between equities and stocks? ›
Equities: This word can be used as a synonym for stocks, or for a specific company's stock. Remember that "equity" describes ownership, and stocks are essentially small positions of ownership in a company. Home equity: This is the value of your ownership stake in your home, as we described above.
Why are stocks and bonds important? ›
A mix of stable, fixed-income investments (to help cushion stock market volatility) and stocks (to provide growth potential over the long haul) is a key ingredient to working toward meeting long-term financial goals.
How do you explain stocks for dummies? ›
Stocks represent shares of ownership in a company, and are listed for sale on a specific exchange. Exchanges track the supply and demand — and directly related, the price — of each stock.
The primary difference between stocks and bonds is that stocks represent ownership in a company while bonds represent debt owed by an entity (usually governments or corporations).
How do bonds work for dummies? ›
The people who purchase a bond receive interest payments during the bond's term (or for as long as they hold the bond) at the bond's stated interest rate. When the bond matures (the term of the bond expires), the company pays back the bondholder the bond's face value.
How do bonds make money? ›
A bond is a loan to a company or government that pays investors a fixed rate of return. The borrower uses the money to fund its operations, and the investor receives interest on the investment. The market value of a bond can change over time.
What are equities investments? ›
An equity investment is money that is invested in a company by purchasing shares of that company in the stock market. These shares are typically traded on a stock exchange.
How do stocks work? ›
Stocks are a type of security that gives stockholders a share of ownership in a company. Companies sell shares typically to gain additional money to grow the company. This is called the initial public offering (IPO). After the IPO, stockholders can resell shares on the stock market.
Are bonds safer than equities? ›
In general, stocks are riskier than bonds, simply due to the fact that they offer no guaranteed returns to the investor, unlike bonds, which offer fairly reliable returns through coupon payments.
What is bond with example? ›
A bond is a fixed-income instrument that represents a loan made by an investor to a borrower (typically corporate or governmental). A bond could be thought of as an I.O.U. between the lender and borrower that includes the details of the loan and its payments.
Is a bond a debt? ›
A bond is a debt obligation, like an Iou. Investors who buy corporate bonds are lending money to the company issuing the bond. In return, the company makes a legal commitment to pay interest on the principal and, in most cases, to return the principal when the bond comes due, or matures.
Are bonds a good investment? ›
There are several benefits that come along with adding bonds to your investment portfolio, and experts suggest that they can help offset some of the risks taken on by more volatile investments. Pro: Bonds can serve as a source of income. Regular interest payments can be a huge selling point for many investors.
