What is the​ ​FINANCIAL SYSTEM​?

 
A financial system is the system
that covers financial transactions
and the exchange of money
between investors, lender and
borrowers. A financial system can
be defined at the global, regional
or firm specific level. Financial
systems are made of intricate and
complex models that portray
financial services, institutions and
markets that link depositors with
investors.
//
The financial system is the group
of institutions in the economy that
help to match one person’s saving
with another person’s
investment.The financial system is
then made up of financial
institutions.It is important to note
that the link between the saver  
and the buyer can be direct or  

indirect.If the link is direct, the borrower will borrow directly from the saver. This works through the financial markets.On the
other hand, if the link is indirect, the borrower will borrow indirectly from the saver. This works through financial
intermediaries.

Banks act as financial

intermediaries because they
stand between savers and
borrowers. Savers place deposits
with banks, and then receive
interest payments and withdraw
money. Borrows receive loans
from banks, and repay the loans
with interest. In turn, banks
return money to saver in the
form of withdrawals, which also
include interest payments from
banks to savers.

NOTE: Savers are suppliers of funds while borrowers are the demanders of funds.
THE IMPORTANCE & FUNCTIONS OF THE FINANCIAL SYSTEM 
- An efficient financial system spurs economic growth
- Serves as the bridge that people require to take better control of their finances and make better investments
- Transfer funds from savers to borrowers/investors.
- The first and foremost function which financial system perform is the channelization the savings of individuals and
making it available for various borrowers which are the companies which take loan in order to increase the
production of goods and services, which in turn increases the overall growth of the economy.
- It is with the help of financial system that one can make payment whenever and wherever he or she wants with the
help of checks, credit card and debit card. In the absence of financial system one has to take cash wherever he or she
goes which would have been impossible.
- Financial system also provide an individual various options when it comes to protecting against various risks like risk
arising from accidents, health related, etc… through various life insurance options.
- Financial system also makes sure that one can liquidate his or her savings whenever he or she wants it and therefore
individuals can have both the things, which involve return on investments as well as comfort that they can liquidate
their investments whenever they want.
- All transactions whether they involve individual buying house or a big company coming with an initial public offer
they are affected smoothly because of financial system.
- Financial system works as an effective conduit for optimum allocation of financial resources in an economy.
- It helps in establishing a link between the savers and the investors.
- Financial system allows ‘asset-liability transformation’. Banks create claims (liabilities) against themselves when they
accept deposits from customers but also create assets when they provide loans to clients.
- Economic resources are transferred from one party to another through financial system.
 ELEMENTS OF THE FINANCIAL SYSTEM 

Financial Institutions/Intermediaries 
Defined as  
...firms that connect borrowers and lenders, provide savers and borrowers access to financial instruments &
markets.
... facilitates the flow of funds between individuals or other economic entities having a surplus of funds
(savers) to those running a deficit of funds (borrowers).
...may refer to an institution, firm or individual who performs intermediation between two or more parties
in financial context. Typically the first party is a provider of a product or service and the second party is a consumer or
customer. A financial intermediary is typically an institution that facilitates the channeling of funds between lenders and
borrowers indirectly. That is, savers (lenders) give funds to an intermediary institution (such as banks), and then that institution
in turn gives those funds to spenders (borrowers). This may be in the form of loans or mortgages.
Financial institutions or financial intermediaries act as half-way houses between the primary lenders and the final
borrowers. They borrow funds (or accept deposits) from those who are willing to give up their current purchasing power and
lend to (or buy securities from) those who require the funds for meeting the current expenditures. Financial institutions are
generally divided into two categories - banks and non-bank financial institutions. The main difference is that the banks possess
while the non-bank do not possess the demand deposits or credit creating power. Banking institutions can be divided into
various categories according to their functions i.e. commercial banks, development banks, investment banks, cooperative banks
and regional rural banks. On the other hand, non-banking finance companies can be categorized as loan and finance companies,
leasing and hire-purchase companies, housing finance companies, insurance companies, chit funds and mutual benefit funds
and other residual finance companies.

Financial Markets 
Defined as  
markets which cater to the financial needs of individuals, firms and institutions required for short as well
as for long period. Financial markets could also mean:

1. The mechanism that facilitate the parking of surplus money of individuals, firms and investment bankers to earn
return.
2. Organizations that facilitate the trade in financial products i.e. Stock exchanges facilitate the trade in stocks, bonds
and warrants.

Hence, financial market is a mechanism that allows people to easily buy and sell (trade) financial securities (such as
stocks and bonds), commodities (such as precious metals or agricultural goods), and other fungible items of value at low
transaction costs and at prices that reflect the efficient market hypothesis. Financial markets facilitate:

1. The raising of capital (in the capital markets);

2. The transfer of risk (in the derivatives markets); and
3. International trade (in the currency markets)

TYPES OF FINANCIAL MARKETS

Money Markets Capital Markets
Money markets are those markets in which only The capital market is that market in which
short-term debt (maturities of less than one year) longer-term debt instruments (maturities of more than one
instruments are traded. year)and equity instruments are traded.
 MONEY MARKETS

market which deals with short-term funds in the economy. It refers to the institutional arrangements facilitating borrowings
and lending of short-term funds. It is the market in which financial institutions, mainly banks lend and borrow money or near
money assets from each other, trade in securities, treasury bills and other financial instruments such as certificates of
deposits or enter into agreements such as Repos and Reverse Repos. In a money market, funds can be borrowed for a short
period varying from a day, a week, a month or 3 to 6 months, sometimes up to one year and against different types of
instruments, such as, treasury bills, bill of exchange, bankers’ acceptances, and bonds etc., called “near money”.

Basic Functions  1. To provide efficient mechanism for adjustment of

liquidity positions of commercial banks, non-bank
financial institutions, business firms and other
investors.
2. To provide a platform for the central bank of the
country to control and manage the money supply
and the liquidity in the economy.
3. To bridge between short term surpluses and deficits.
4. To provide a realistic price for short term money.

Participants  Central Government

State Government
Public Sector Undertakings
Scheduled Commercial Banks
Private Sector Companies
Provident Funds
Life Insurance Companies
General Insurance Companies
Mutual Funds
Non-banking Financial Companies
Primary Dealers

CAPITAL MARKETS

The term capital market refers to the institutional arrangements for facilitating the borrowing and lending of long-term
funds. A capital market may be defined as an organised mechanism for effective and efficient transfer of money or financial
resources from the investing parties, i.e. individuals or institutional savers to the entrepreneurs engaged in industry or
commerce and that would either be in the private or public sectors of an economy. All the long term capital needs are met
by the capital market. Capital market is a central coordinating and directing mechanism for free and balanced flow of
financial resources into the economic system operating in a country.

Basic Functions 1.
2.
Provides a platform for raising long term funds
Acts as an intermediary between buyers and sellers of securities
3. Facilitates an organized trading mechanism for stock and securities.
4. Provides a standard price for the securities.
5. Nexus between savings and investment.

Consists of... 1. Stock markets​, which provide financing through the issuance of shares or common
stock, and enable the subsequent trading thereof.
2. Bond markets​, which provide financing through the issuance of Bonds, and enable
the subsequent trading thereof.
3. Derivative market where derivative products like stock futures, index futures and
options are traded. Financial derivative is an agreement between two parties for
buying or selling an underlying asset (Stock or index) whose value is derived from
the underlying financial assets or claim.
 Types 
PRIMARY MARKET SECONDARY MARKET
-provide avenues for buyers and -provide a venue for investors and
sellers to buy and sell stocks and traders to purchase instruments
bonds. that have been previously bought.

-is the market where initial issues -consists of stock exchanges and
are sold and bought. When a over the counter exchanges. In the
company issues shares for the first secondary market the previously
time, it is trade through primary issued securities are sold and
market .This market is also known bought and it passes from one
as New Issue Market (NIM). The investor to another. Stock brokers
primary market is facilitated by the play an important role as the
intermediaries like issue managers, intermediaries between stock
issuing banks, registrars, exchanges and the investors.
book-runners etc. who
intermediate between investors
and issuers.

 
 

Financial Instruments 
Defined as  
are legal agreements that require one party to pay money or something else of value or to promise to pay
under stipulated conditions to a counterparty in exchange for the payment of interest, for the acquisition of rights, for
premiums, or for indemnification against risk. In exchange for the payment of the money, the counterparty hopes to
profit by receiving interest, capital gains, premiums, or indemnification for a loss event.
A financial instrument can be an actual document, such as a stock certificate or a loan contract, but, increasingly,
financial instruments that have been standardized are stored in an electronic book-entry system as a record, and the
parties to the contract are also recorded.

TYPES OF FINANCIAL INSTRUMENTS

● Exchanges of money for future interest payments and repayment of principal.
○ Loans and Bonds​.
■ A lender gives money to a borrower in exchange for regular payments of interest and principal.
○ Asset-Backed Securities.
■ Lenders pool their loans together and sell them to investors. The lenders receive an immediate
lump-sum payment and the investors receive the payments of interest and principal from the
underlying loan pool.
● Exchanges of money for possible capital gains or interest.
○ Stocks.
■ A company sells ownership interests in the form of stock to buyers of the stock.
○ Funds.
■ Includes mutual funds, exchange-traded funds, real estate investment trusts, hedge funds, and
many other funds. The fund buys other securities earning interest and capital gains which
increases the share price of the fund. Investors of the fund may also receive interest payments.
● Exchanges of money for possible capital gains or to offset risk.
○ Options and Futures.
 ■ Options and futures are bought and sold either for capital gains or to limit risk. For instance, the
holder of XYZ stock may buy a put, which gives the holder of the put the right to sell XYZ stock for
a specific price, called the strike price. Hence, the put increases in value as the underlying stock
declines. The seller of the put receives money, called the premium, for the promise to buy XYZ
stock at the strike price before the expiration date if the put buyer exercises her rights. The put
seller, of course, hopes that the stock stays above the strike price so that the put expires
worthless. In this case, the put seller gets to keep the premium as a capital gain.
○ Currency.
■ Currency trading, likewise, is done for capital gains or to offset risk. It can also be used to earn
interest, as is done in the carry trade. For instance, if a trader believed that the Euro was going to
decline with respect to the United States dollar, then he could buy dollars with Euros, which is the
same thing as selling Euros for dollars. If the Euro does decline with the respect to the dollar, then
the trader can close the position by buying more Euros with the dollars received in the opening
trade.
○ Swaps​.
■ Swaps are an exchange of interest rate payments calculated as a percentage of a notional
principal that is paid at periodic intervals. One leg of the swap pays a fixed rate of interest and the
other leg pays a floating rate of interest. However, only the net amount is exchanged. For
instance, if the interest based on the floating rate is $1000 greater than the interest based on the
fixed-rate on a payment date, then the party receiving the fixed rate would pay $1000 to the party
receiving the floating rate. The receiver of the fixed rate of interest enters into the swap usually to
offset risk while the receiver of the floating rate generally hopes to profit from changes in the
market interest rate. Usually, the floating rate is calculated as a spread above LIBOR or some
other benchmark, such as Treasuries with comparable terms. If both legs of the swap pay in the
same currency, and the swap is known as an interest rate swap, since both the fixed-rate and the
floating rate are paid in the same currency. By contrast, a currency swap is the exchange of
interest rate payments paid in different currencies, so the net amount is calculated based on the
exchange rate on the payment date.
● Exchanges of money for protection against risk.
○ Insurance.
■ Insurance contracts promise to pay for a loss event in exchange for a premium. For instance, a car
owner buys car insurance so that he will be compensated for a financial loss that occurs as the
result of an accident.

TYPES OF SECURITIES
A security is a fungible, negotiable financial instrument that holds some type of monetary value. It represents an
ownership position in a publicly-traded corporation (via stock), a creditor relationship with a governmental body or a
corporation (represented by owning that entity's bond), or rights to ownership as represented by an option.
The entity that creates the securities for sale is known as the issuer, and those that buy them are, of course, investors.
Generally, securities represent an investment and a means by which municipalities, companies and other commercial
enterprises can raise new capital. Companies can generate a lot of money when they go public, selling stock in an initial public
offering (IPO), for example. City, state or county governments can raise funds for a particular project by floating a municipal
bond issue. Depending on an institution's market demand or pricing structure, raising capital through securities can be a
preferred alternative to financing through a bank loan.
On the other hand, purchasing securities with borrowed money, an act known as buying on a margin, is a popular investment
technique. In essence, a company may deliver property rights, in the form of cash or other securities, either at inception or in
default, to pay its debt or other obligation to another entity. These collateral arrangements have been growing of late,
especially among institutional investors.
 DEBT SECURITIES
- Debt security refers to a debt instrument, such as a government bond, corporate bond, certificate of deposit (CD),
municipal bond or preferred stock, that can be bought or sold between two parties and has basic terms defined, such as
notional amount (amount borrowed), interest rate, and maturity and renewal date. It also includes collateralized securities,
such as collateralized debt obligations (CDOs), collateralized mortgage obligations (CMOs), mortgage-backed securities issued
by the Government National Mortgage Association (GNMAs) and zero-coupon securities.

- represents money that is borrowed and must be repaid, with terms that stipulates the size of the loan, interest rate
and maturity or renewal date. Debt securities, which include government and corporate bonds, certificates of deposit (CDs) and
collateralized securities (such as CDOs​ and CMOs​), generally entitle their holder to the regular payment of interest and
repayment of principal (regardless of the issuer's performance), along with any other stipulated contractual rights (which do
not include voting rights). They are typically issued for a fixed term, at the end of which they can be redeemed by the issuer.
Debt securities can be secured (backed by collateral) or unsecured, and, if unsecured, may be contractually prioritized over
other unsecured, subordinated debt in the case of a bankruptcy.

Types of Debt Securities  

Corporate Bonds  Municipal Bonds 

Corporate bonds are debt securities issued by corporations. Municipal bonds are issued by states or municipalities to
Interest is generally paid semi-annually. The investor fund projects or borrow money to meet general obligations.
receives the face amount of the bond at the bond’s maturity Municipal bond interest is exempt from federal income
date. Interest rates depend on the creditworthiness of the taxes. Most municipal bond interest is exempt from state
issuing company and the duration of the bond. The bond’s and local taxes for taxpayers of the state in which they are
duration is the length of time until the maturity date. Longer issued. Capital gain from the sale of municipal bonds is
duration bonds pay higher rates of interest, as the investor is taxable income on both the federal and state levels. Interest
assuming greater risk. Some corporate bonds have a call rates are lower than corporate bonds. Municipal bonds may
feature, where the corporation has the right to repurchase be revenue bonds, where revenue from a specific project,
the bond at a specific date prior to the bond’s maturity. such as an airport terminal, is dedicated to making interest
payments on the bonds.

Treasury Bills, Notes and Bonds  Savings Bonds 

The U.S. Treasury issues Treasury bills, Treasury notes, and Series EE savings bonds are another form of debt security.
Treasury bonds. Treasury bills have durations of less than Series EE bonds accrue interest quarterly; interest is paid
one year; Treasury notes have durations between one and when the bond is redeemed. Some investors can receive tax
ten years; Treasury bonds have durations over ten years. benefits when using Series EE bonds for education funding.
Treasury debt is considered amongst the safest debt in the Series 1 bonds, a second class of savings bonds, are very
world, because it's backed by the U.S. government's full similar but are adjusted for inflation rather than offering a
debt-paying capacity. Correspondingly, interest rates for fixed rate throughout their lifetime.
these federal instruments tend to be lower than interest
rates of other debt securities.

Packaged Debt Securities  Commercial Paper 

Some debt securities are pools of individual debts. Examples Large, financially secure corporations finance their short
are collateralized mortgage obligations and collateralized term obligations by selling "commercial paper," a short-term
debt obligations. These pools of debt securities are packaged promissory note. It's sold at a discount and then matures to
together and sold to investors as a single debt security. face value, providing the buyer with a return. Commercial
paper is sold in units of $100,000 or more, so it's primarily
purchased by institutional investors such as mutual funds
rather than individual investors.
Types of Commercial Paper 
The UCC identifies four basic kinds of commercial paper: promissory notes, drafts, checks, and certificates of deposit.
The Most fundamental type of commercial paper is a promissory note, a written pledge to pay money. A promissory note is a
two-party paper. The maker is the individual who promises to pay while the payee or holder is the person to whom payment is
promised. The payee can be either a specifically named individual or merely the bearer of the instrument who has it in his or
her physical possession when he or she seeks to be paid according to its terms. A note payable to "bearer" can be paid tothe
person who presents it for remuneration. Such an instrument is said to be bearer paper.
A promissory note that is payable on demand can be redeemed by the payee at any time, whereas a time note has a
date for payment on its face that establishes the date when the holder will have an enforceable right to receive payment under
it.There is no obligation to pay a time note until the date designated on its face.
The ordinary purpose of a promissory note is to borrow money. Promissory notes should not be confused with credit or loan
agreements, which are separate instruments that are usually signed at the same time as promissory notes, but which merely
describe the terms of the transactions.
A promissory note serves as documentary evidence of a debt. It can be endorsed and sold at a discount to other
parties, and each subsequent endorser becomes secondarily liable for the amount specified on the face of the instrument. A
number of Consumer Credit dealings are funded through the use of promissory notes.
Certain types of promissory notes are sold at a discount, such as U.S. savings bonds and corporation bonds. Such an
instrument is sold for an amount below its face value and can subsequently be redeemed on the due date or date of maturity
for the entire face amount. The interest obtained by the holder of the instrument is the difference between the purchase price
and the redemption price. In certain instances, bonds that are not redeemed immediately upon maturity accumulate interest
following the due date and are ultimately worth more than their face value when redeemed at a later time. If such bonds are
cashed in before maturity, the holder receives less than the face value.
A draft, also known as a bill of exchange, is a three-party paper ordering the payment of money. The drawer is the
individual issuing the order to pay, while the drawee is the party to whom the order to pay is given. As in the case of a
promissory note,the payee is either a specified individual or the bearer of the draft who is to receive payment according to its
terms. The draft is made payable on demand or on a certain date. A common example of a draft is a cashier's check.
A draft is often used in business to obtain payment for items that must be shipped over long distances. Drafts are
often the preferred method of payment for purchasers who want to examine goods prior to payment or who do not have the
necessary funds available at the time of sale. The vendor might have reservations concerning the buyer's credit and desire
payment as soon as possible. The procedure ordinarily followed in such instances is that upon shipment of the goods, the seller
receives a bill of lading from the carrier. The bill of lading also serves as a certificate of title to the goods, which is ordinarily in
the seller's name.
Upon shipment, the seller draws a draft against the buyer-drawee, who is required to pay the draft. The seller's bank
is named as the payee. The seller endorses the bill of lading to the payee and attaches the bill to the draft. The seller can either
negotiate these instruments to the payee at a discount or use them as security for a loan. Subsequently, the papers are
endorsed by the seller's bank and delivered to a correspondent bank in the community where the buyer is located. The
correspondent bank seeks payment of the draft from the buyer and when payment is made, the bank transfers ownership of
the goods from seller to buyer by endorsing the bill of lading to the buyer. The buyer can then obtain the goods from the carrier
upon presentation of the bill of lading, which demonstrates his or her title to the shipped goods.
A check is a specific kind of draft, which is drawn on a bank and payable on demand to a particular individual or to the
bearer, in which case it can be written payable to "cash."
An individual who opens a checking account is engaged in a contractual relationship with a bank. The individual
agrees to deposit money therein, while the bank agrees that it is indebted to the depositor for the amount in the account, in
addition to promising to honor checks written for payment against the account when there are sufficient funds on hand to do
so.
A certificate of deposit, frequently referred to as a CD, is a written recognition by a bank of the acquisition of a sum of
money from a depositor for a designated period of time at a specified interest rate, coupled with a promise of repayment. The
bankis both the maker and the drawee, and the individual making the deposit is the payee.
Ordinarily, certificates of deposit come in specific denominations that vary according to the length of the term that
the bank will hold the funds and are available only for large sums of money. They are used mainly by corporations and
individuals as savings devices since they generally bear higher interest rates than ordinary savings accounts. They must,
however, be lefton deposit for the designated time period. Ordinarily, a CD can be cashed in prior to the date of maturity, but
some interest will be forfeited. Depending upon the provisions of the CD, however, a bank may have the legal right to refuse to
close an account before the expiration of the designated date of maturity.

EQUITY SECURITIES
- represents ownership interest held by shareholders in an entity (a company, partnership or trust), realized in the
form of shares of capital stock, which includes shares of both common and preferred stock. Holders of equity securities are
typically not entitled to regular payments (though equity securities often do pay out dividends), but they are able to profit from
capital gains when they sell the securities (assuming they've increased in value, naturally). Equity securities do entitle the
holder to some control of the company on a pro rata basis, via voting rights. In the case of bankruptcy, they share only in
residual interest after all obligations have been paid out to creditors.

DIFFERENCE BETWEEN DEBT SECURITIES AND EQUITY SECURITIES

Equity securities represent a claim on the earnings and assets of a corporation, while debt securities are investments
into debt instruments. For example, a stock is an equity security, while a bond is a debt security. When an investor buys a
corporate bond, he is essentially loaning the corporation money, and he has the right to be repaid the principal and interest on
the bond. In contrast, when someone buys a stock from a corporation, he essentially buys a piece of the company. If the
company profits, he profits as well, but if the company loses money, his stock also loses money. In the event that the
corporation goes bankrupt, it pays bondholders before shareholders.

THE DIFFERENCE BETWEEN STOCKS AND BONDS 

 
Stocks Are Ownership Stakes, Bonds are Debt 
Stocks and bonds represent two different ways for an entity to raise money to fund or expand their operations. When
a company issues stock, it is selling a piece of itself in exchange for cash. When an entity issues a bond, it is issuing debt with
the agreement to pay interest for the use of the money.

Stocks​ are simply shares of individual companies. Bonds, ​on the other hand, represent debt. A
Here’s how it works: say a company has made it through its government, corporation, or other entity that needs to raise
start-up phase and has become successful. The owners wish cash borrows money in the public market and subsequently
to expand, but they are unable to do so solely through the pays interest on that loan to investors.
income they earn through their operations. As a result, they Each bond has a certain par value (say, $1000) and pays a
can turn to the financial markets for additional financing. coupon to investors. For instance, a $1000 bond with a 4%
One way to do this is to split the company up into “shares,” coupon would pay $20 to the investor twice a year ($40
and then sell a portion of these shares on the open market annually) until it matures. Upon maturity, the investor is
in a process known as an “​initial p​u​blic offering​,” or IPO. A returned the full amount of his or her original principal
person who buys Stock, is therefore buying an actual share except for the rare occasion when a bond defaults (i.e., the
of the company, which makes him or her a part owner – issuer is unable to make the payment).
however small. This is why Stock is also referred to as
“equity.”

The Difference Between Stocks and Bonds for Investors 

Since each share of stock represents an ownership stake in a company – meaning the owner shares in the profits and
losses of the company - someone who invests in the stock can benefit if the company performs very well and its value increases
over time. At the same time, he or she runs the risk that the company could perform poorly and the stock could go down – or,
in the worst-case scenario (bankruptcy) – disappear altogether.
Individual stocks and the overall stock market tend to be on the riskier end of the investment spectrum in terms of
their volatility and the risk that the investor could lose money in the short term. However, they also tend to provide superior
long-term returns. Stocks are therefore favored by those with a long-term investment horizon and a tolerance for short-term
risk.
Bonds lack the powerful long-term return potential of stocks, but they are preferred by investors for whom income is
a priority. Also, bonds are less risky than stocks. While their prices fluctuate in the market – sometimes quite substantially in
the case of higher-risk market segments - the vast majority of bonds tend to pay back the full amount of principal at maturity,
and there is much less risk of loss than there is with stocks.

COMMON STOCKS AND PREFERED STOCKS  

Common stock and preferred stock are the two main types of stocks that are sold by companies and traded among
investors on the open market. Each type gives stockholders a partial ownership in the company represented by the stock.
Despite some similarities, common stock and preferred stock have some significant differences, including the risk involved with
ownership. It’s important to understand the strengths and weaknesses of both types of stocks before purchasing them.

Common Stock  Preferred Stock 

Common stock is the most common type of stock that is Preferred stock is generally considered less volatile than
issued by companies. It entitles shareholders to share in the common stock but typically has less potential for profit.
company’s profits through dividends and/or capital Preferred stockholders generally do not have voting rights,
appreciation. Common stockholders are usually given voting as common stockholders do, but they have a greater claim
rights, with the number of votes directly related to the to the company’s assets. Preferred stock may also be
number of shares owned. Of course, the company’s board of “callable,” which means that the company can purchase
directors can decide whether or not to pay dividends, as well shares back from the shareholders at any time for any
as how much is paid. reason, although usually at a favorable price.

Owners of common stock have “preemptive rights” to Preferred stock shareholders receive their dividends before
maintain the same proportion of ownership in the company common stockholders receive theirs, and these payments
over time. If the company circulates another offering of tend to be higher. Shareholders of preferred stock receive
stock, shareholders can purchase as much stock as it takes to fixed, regular dividend payments for a specified period of
keep their ownership comparable. time, unlike the variable dividend payments sometimes
offered to common stockholders. Of course, it’s important to
Common stock has the potential for profits through capital remember that fixed dividends depend on the company’s
gains. The return and principal value of stocks fluctuate with ability to pay as promised. In the event that a company
changes in market conditions. Shares, when sold, may be declares bankruptcy, preferred stockholders are paid before
worth more or less than their original cost. Shareholders are common stockholders. Unlike preferred stock, though,
not assured of receiving dividend payments. Investors common stock has the potential to return higher yields over
should consider their tolerance for investment risk before time through capital growth. Remember that investments
investing in common stock​. seeking to achieve higher rates of return also involve a
higher degree of risk.
When You Should Prefer Preferred Stocks Over Common Ones 
A preferred stock is a share of ownership in a public company. It has some qualities of a common stock and some of a
bond. The price of a share of both preferred and common stock varies with the earnings of the company. Both trade through
brokerage firms. Bond prices on the other hand, vary with the company's ability to pay the bond it, as rated by Standard &
Poor's.
Preferred stocks pay a dividend like common stock.
The difference is that preferred stocks pay an agreed-upon dividend at regular intervals. This quality is similar to that
of bonds. Common stocks may pay dividends depending on how profitable the company is. Preferred stock dividends are often
higher than common stock dividends. The dividend can be adjustable and vary with Libor or it can be a fixed amount that never
varies.
Preferred stocks are also like bonds in that you’ll get your initial investments back if you hold them until maturity.
That's 30 years to 40 years in most cases. Common stock values can fall to zero. If that happens, you'd get nothing.
Companies that issue preferred stocks can recall them before maturity by paying the issue price. Like bonds and unlike stocks,
preferred stocks do not confer any voting rights.

When You Should Buy Preferred Stocks 

You should consider preferred stocks when you need a steady stream of income.
This is true in particular when interest rates are low. It’s because preferred stock dividends pay a higher income stream than
bonds. Although lower, the income is more stable than stock dividends.
You should sell them when interest rates rise. This is because that’s when they start to lose value. It’s true with bonds
as well.
The fixed income stream becomes less valuable as interest rates push up the returns on other investments.
Preferreds could also lose value when stock prices rise. That's because the company may call them in. It means they buy the
preferred stocks back from you before the prices get any higher.

Preferred Stocks Versus Common Stocks 

This table illustrates the difference between preferred stocks, common stocks and bonds.

Feature  Preferred   Common   Bond 

Ownership of Company  Yes Yes No

Voting Rights  No Yes No

Price of Security Is Based on:  Earnings Earnings S&P Rating

Dividends  Fixed Varies Fixed

Value if Held to Maturity  Full Varies Full

Order Paid if Company Defaults   Second Third First

Types of Preferred Stocks 
Convertible preferred stocks​ ​have the option of being converted into common stock at some point in the future.
What determines when this happens? Three things:
1. The corporation's Board of Directors may vote for a conversion.
2. You might decide to convert. You would only exercise this option if the price of the common stock is more than the
net present value of your preferreds. The net present value includes the expected dividend payments and the price
you would receive when the life of the preferred is over.
3. The stock might have automatically converted on a predetermined date.

Cumulative preferred stocks​ allow companies to suspend dividend payments when times are bad. But they must pay
all the missed dividend payments when times are good again. In fact, they must do this before they can make any dividend
payments to common stockholders. Preferred stocks without this advantage are called non-cumulative stocks.

Redeemable preferred stocks​ gives the company the right to redeem the stock at any time after a certain date. The
option usually describes the price the company will pay for the stock. The redeemable date is often not for a few years. These
stocks pay a higher dividend to compensate for the added redemption risk. Why? The company could call for redemption if
interest rates drop. They would issue new preferreds at the lower rate, and pay a smaller dividend instead.
That means less profit for the investor.

Why Companies Issue Preferred Stock 

Companies use preferred stocks to raise capital for growth. The corporation’s ability to suspend the dividends is its
biggest advantage over bonds. It just requires a vote of the board. They run no risk of being sued for default. If the company
doesn't pay the interest on its bonds, it defaults.
Companies also use preferred stocks to transfer corporate ownership to another company. For one thing, companies
get a tax write-off on the dividend income of preferred stocks. In fact, they don't have to pay taxes on the first 80 percent of
income received from dividends. individual investors don't get the same tax advantage. Second, companies can sell preferred
stocks quicker than common stocks. It’s because the owners know they will be paid back before the owners of common stocks
will.
This advantage was why the U.S. Treasury bought shares of preferred stocks in the banks as part of Troubled Asset
Relief Program. It capitalized the banks so they wouldn't go bankrupt. At the same time, the Treasury wanted to protect the
government. Taxpayers would get paid back before the common shareholders if the banks defaulted at all.
Preferred stocks are often issued as a last resort. Companies use it after they've gotten all they can from issuing
common stocks and bonds. That's because preferred stocks are more expensive than bonds. The dividends paid by preferred
stocks come from the company's after-tax profits. These expenses are not deductible. The interest paid on bonds is
tax-deductible. This runs cheaper for the company. (Source: “The Power of Preferred Stocks,” Motley Fool, April 24, 2001.)