2 – M1L2 01 Stock Pt II V1

Let’s take a moment to clarify the meaning of some words you might hear when discussing stock. A security is a financial instrument that has some type of monetary value. Some securities that you might have heard of are stocks, bonds, and options. Securities can be classified into three broad types; debt securities, derivative securities, and equity securities. Debt securities represent money that is owed and must be repaid like government or corporate bonds, or certificates of deposit. Debt securities are also called fixed-income securities because they promise a stream of income over time in the form of interest either at a fixed rate or at a rate determined by a specific formula. Derivative securities such as options or futures contracts are so-named because their values depend on the prices of other assets. For example, an option is a contract which gives the buyer the right but not the obligation to buy or sell an underlying asset at a specified price on a specified date. An example of an option contract would be employee stock options. As part of employee incentive programs, employers frequently offer employees the option to buy companies stock at a lower price called the strike price, and later sell it on the open market to make a profit. On the other hand, a futures contract obligates the buyer to buy or the seller to sell an asset at a predetermined price at a specified time in the future. For example, say, a dairy farmer concurrently sell milk for $2 a gallon. Next month, he plans to sell 200 gallons of milk, but he’s concerned that fluctuations in the market price for milk will erode his profits. So he enters into a futures contract with an investor. By doing so, he is obligated to sell 200 gallons of milk on the agreed date, but he’s guaranteed to receive $400 regardless of the market price of milk at that time. This type of agreement would protect him from the risk of catastrophic loss if the price of milk tanks, but will also limit his ability to profit if the price of milk rises. Then there’s that last category, equity securities. Let’s break that phrase down. Equity is the value of an owned asset minus the amount of all debts or liabilities on that asset. So if you own a $15,000 car, but you owe a $5,000 loan against it, the car represents $10,000 of equity. The word equity can have somewhat different meanings in different contexts. But in general, you can think of equity as the net value of something owned. Stocks are called equity securities because they represent ownership in a firm. One more thing, a security representing ownership interest in a private company is called private equity.

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