AFM 121: Introduction to Global Financial Markets

Estimated study time: 26 minutes

Table of contents

Sources and References

Primary textbook — Sean Cleary, Canadian Securities Course Study Guide, 4th Edition (CSI Global Education, 2022).

Supplementary — Zvi Bodie, Alex Kane, and Alan Marcus, Essentials of Investments, 13th Edition (McGraw-Hill, 2024); Richard Brealey, Stewart Myers, and Franklin Allen, Principles of Corporate Finance, 13th Edition (McGraw-Hill, 2020).

Online resources — MIT OpenCourseWare 15.401 Finance Theory I; CFA Institute Learning Ecosystem (introductory modules); Bank of Canada Financial System Review (open access).

Chapter 1: The Role of Finance in the Global Economy

The Purpose of Financial Markets

Finance is fundamentally concerned with the allocation of scarce capital across time and risk. Financial markets are the institutional infrastructure through which savers transfer purchasing power to borrowers and investors, enabling productive investment that would otherwise be impossible. Without well-functioning financial markets, households with surplus funds could not efficiently channel those resources to firms with profitable projects, and the overall level of economic activity would be substantially reduced.

The global economy depends on several key financial functions. Capital formation occurs when financial markets direct savings toward the construction of productive assets — factories, research, infrastructure, human capital. Price discovery is the process by which markets aggregate dispersed information into asset prices, signalling where resources are most productively deployed. Risk sharing allows individuals and firms to transfer risks they are poorly positioned to bear toward counterparties better suited to absorb them. Liquidity provision means investors can convert assets to cash quickly, lowering the premium they demand for holding illiquid investments.

Financial market: An organized mechanism through which buyers and sellers exchange financial claims (securities, currencies, derivatives) at prices determined by supply and demand.

Financial Intermediaries

Between ultimate savers and ultimate borrowers stand financial intermediaries — banks, insurance companies, pension funds, mutual funds, and investment dealers. These institutions reduce transaction costs, overcome information asymmetries, and provide maturity transformation (converting short-term deposits into long-term loans).

A bank accepts deposits (liabilities) and makes loans (assets), earning the net interest margin between lending and deposit rates. Investment dealers (broker-dealers) facilitate securities issuance in primary markets and trading in secondary markets. Mutual funds and ETFs pool investor capital to achieve diversification and professional management at lower cost than individual investors could achieve alone.

The distinction between direct finance (borrower issues securities directly to lenders) and indirect finance (intermediary stands between them) is important. Canada’s financial system relies heavily on chartered banks for indirect finance, while the United States has a proportionally larger direct finance sector.

Regulation of Financial Markets

Financial markets operate within regulatory frameworks designed to protect investors, ensure fair dealing, and maintain systemic stability. In Canada, securities regulation is a provincial responsibility, with each province having its own securities commission (e.g., the Ontario Securities Commission). The Canadian Securities Administrators (CSA) coordinates national policy. Banking regulation falls under federal jurisdiction via the Office of the Superintendent of Financial Institutions (OSFI).

Key regulatory principles include disclosure (issuers must publish material information), fair dealing (market participants must treat clients fairly), and systemic risk management (regulators monitor leverage and interconnectedness to prevent crises from spreading).

Chapter 2: Financial Markets — Structure and Instruments

Primary vs. Secondary Markets

Primary market: The market in which new securities are issued for the first time, with proceeds going to the issuing entity. An initial public offering (IPO) and a seasoned equity offering (SEO) are primary market transactions.

Secondary market: The market in which previously issued securities are traded among investors. The Toronto Stock Exchange (TSX) and the New York Stock Exchange (NYSE) are secondary markets. Secondary markets provide liquidity to primary market investors and facilitate continuous price discovery.

When a company issues new shares through an IPO, it receives the proceeds. When investors subsequently trade those shares on the TSX, the company receives nothing — only the investors exchange cash and ownership. The existence of a liquid secondary market makes primary market investors more willing to participate, lowering the cost of capital for issuers.

Types of Financial Markets

Money markets trade short-term, highly liquid debt instruments with maturities of one year or less: Treasury bills, commercial paper, bankers’ acceptances, and repurchase agreements (repos). These instruments are near-cash substitutes and serve primarily as tools for cash management.

Capital markets trade longer-term securities: government and corporate bonds (fixed-income markets) and equities (stock markets). Capital market instruments are used to finance long-term investment.

Foreign exchange (forex) markets are the largest and most liquid financial markets in the world, with daily turnover exceeding $7 trillion. They enable international trade and investment by allowing conversion between currencies.

Derivatives markets trade contracts whose value is derived from an underlying asset. Options, futures, forwards, and swaps all belong to this category. Derivatives serve risk management (hedging) and speculative purposes.

Major Financial Instruments

Equities (Common Shares)

A share of common stock represents a residual ownership claim on a corporation’s assets and earnings. Shareholders receive dividends (if declared by the board) and bear the ultimate upside and downside of the firm’s performance. Common shareholders vote on major corporate decisions. The value of a share is theoretically the present value of all future dividends — a relationship formalized in dividend discount models.

Residual claim: Common shareholders receive what is left after all other claimants (employees, creditors, preferred shareholders, tax authorities) have been paid. This makes equity the riskiest financial claim in the capital structure.

Preferred shares occupy a middle ground between debt and equity. They typically pay a fixed dividend and have priority over common shares in the event of liquidation, but they usually lack voting rights and are perpetual (no maturity date).

Fixed-Income Securities

A bond is a debt instrument that obligates the issuer to pay periodic interest (the coupon) and to repay the face value (principal) at maturity. The bond’s price equals the present value of all future cash flows discounted at the market yield. Government bonds (issued by federal or provincial governments) carry no default risk in domestic currency terms; corporate bonds carry credit risk and therefore trade at a spread above comparable government bonds.

Pooled Investment Vehicles

Mutual funds issue redeemable units to investors and invest the proceeds in a diversified portfolio. The fund’s Net Asset Value per unit (NAVPU) is calculated daily as total assets minus liabilities divided by units outstanding. Exchange-Traded Funds (ETFs) trade on exchanges like stocks throughout the day and typically track an index at very low cost. Closed-end funds issue a fixed number of shares at inception and trade on exchanges at prices that may differ from underlying NAV.

Derivatives

A futures contract is a standardized agreement to buy or sell an asset at a specified future date and price, traded on organized exchanges with daily mark-to-market settlement. A forward contract is a bespoke version traded over-the-counter (OTC). An option gives the holder the right (not obligation) to buy (call) or sell (put) an asset at a predetermined strike price.

Chapter 3: Time Value of Money

The Fundamental Principle

A dollar received today is worth more than a dollar received in the future because today’s dollar can be invested to earn returns. This is the time value of money (TVM), the cornerstone of all financial valuation. TVM calculations underpin bond pricing, stock valuation, project appraisal (NPV), mortgage analysis, and retirement planning.

Compounding and Future Value

If you invest a principal amount $PV$ at an annual interest rate $r$ for $n$ periods, the future value is:

\[ FV = PV \times (1 + r)^n \]

You invest $1,000 today at 6% per year compounded annually. After 10 years: \[ FV = 1{,}000 \times (1.06)^{10} = 1{,}000 \times 1.7908 = \$1{,}790.85 \]

When interest is compounded more frequently than annually — say monthly — the effective annual rate (EAR) rises above the nominal rate:

\[ EAR = \left(1 + \frac{r_{nom}}{m}\right)^m - 1 \]

where $m$ is the number of compounding periods per year. A nominal rate of 12% compounded monthly yields an EAR of $ (1.01)^{12} - 1 = 12.68\% $.

Discounting and Present Value

The present value of a future cash flow $FV$ received $n$ periods from now, discounted at rate $r$:

\[ PV = \frac{FV}{(1 + r)^n} \]

The factor $ \frac{1}{(1+r)^n} $ is the discount factor. As $r$ rises, discount factors fall, meaning future cash flows become worth less today. This inverse relationship between interest rates and present values is a fundamental law of finance.

Annuities

An annuity is a finite sequence of equal, evenly-spaced cash flows. The present value of an ordinary annuity (payments at end of each period) of $C$ per period for $n$ periods at rate $r$:

\[ PV_{annuity} = C \times \frac{1 - (1+r)^{-n}}{r} \]

The future value of an ordinary annuity:

\[ FV_{annuity} = C \times \frac{(1+r)^n - 1}{r} \]

You deposit $500 at the end of each year for 5 years into an account earning 4% annually. The future value at the end of year 5: \[ FV = 500 \times \frac{(1.04)^5 - 1}{0.04} = 500 \times 5.4163 = \$2{,}708.16 \]

Perpetuities

A perpetuity pays a fixed amount $C$ per period forever. Its present value simplifies elegantly:

\[ PV_{perpetuity} = \frac{C}{r} \]

A growing perpetuity pays $C_1$ in the first period, growing at rate $g$ per period thereafter (assuming $g < r$):

\[ PV_{growing\ perpetuity} = \frac{C_1}{r - g} \]

This formula is the foundation of the Gordon Growth Model for stock valuation.

Net Present Value

The Net Present Value (NPV) of a project is the sum of present values of all incremental cash flows, including the initial investment:

\[ NPV = -C_0 + \sum_{t=1}^{n} \frac{C_t}{(1+r)^t} \]

A positive NPV means the project creates value; it earns more than the opportunity cost of capital $r$. NPV is the theoretically correct criterion for capital budgeting decisions.

Chapter 4: Financial Assets — Equities

Equity Valuation Frameworks

The value of a share of stock equals the present value of all future cash flows an investor expects to receive. Two broad approaches dominate: dividend discount models (DDM) and relative valuation (price multiples).

Dividend Discount Models

The DDM expresses the value $P_0$ of a share as the present value of the infinite stream of future dividends:

\[ P_0 = \sum_{t=1}^{\infty} \frac{D_t}{(1+k_e)^t} \]

where $D_t$ is the dividend in period $t$ and $k_e$ is the required return on equity. The Gordon Growth Model assumes dividends grow at a constant rate $g$:

\[ P_0 = \frac{D_1}{k_e - g} \]

A firm just paid a dividend of $2.00 (i.e., D_0 = $2.00). Dividends are expected to grow at 5% per year indefinitely. The required return on equity is 10%. \[ D_1 = 2.00 \times 1.05 = \$2.10 \]\[ P_0 = \frac{2.10}{0.10 - 0.05} = \frac{2.10}{0.05} = \$42.00 \]

The model is sensitive to assumptions about $g$ and $k_e$; small changes in either produce large swings in the estimated price.

Price Multiples

Relative valuation compares a stock’s price to a fundamental: earnings (P/E ratio), book value (P/B), sales (P/S), or cash flow (P/CF). These multiples are benchmarked against historical averages, peer companies, or market indices to assess relative cheapness or expensiveness.

The Price/Earnings (P/E) ratio is the most widely used:

\[ P/E = \frac{Market\ Price\ per\ Share}{Earnings\ per\ Share} \]

A high P/E may reflect high expected growth, low risk, or overvaluation. Context is essential.

Stock Market Indexes

A stock market index aggregates the prices of a basket of stocks into a single number, providing a benchmark for market performance. Indexes differ in construction:

Price-weighted (e.g., Dow Jones Industrial Average): each stock’s weight equals its price. Higher-priced stocks have greater influence regardless of market capitalization.
Value-weighted (e.g., S&P 500, TSX Composite): each stock’s weight equals its share of total market capitalization. More economically sensible.
Equal-weighted: each stock receives the same weight, giving more influence to smaller companies.

Chapter 5: Financial Assets — Bonds and Fixed Income

Bond Terminology and Cash Flows

A bond’s key characteristics are its face value (par value, typically $1,000), coupon rate (annual interest expressed as a percentage of par), maturity date, and yield to maturity (YTM).

The price of a bond equals the present value of its coupon payments (an annuity) plus the present value of the face value (a lump sum):

\[ P = \sum_{t=1}^{n} \frac{C}{(1+y)^t} + \frac{F}{(1+y)^n} \]

where $C$ is the periodic coupon, $F$ is the face value, $n$ is the number of periods, and $y$ is the periodic yield.

A 5-year bond with face value $1,000, annual coupon rate 6% (so coupon = $60/year), and a yield to maturity of 8%. \[ P = 60 \times \frac{1 - (1.08)^{-5}}{0.08} + \frac{1{,}000}{(1.08)^5} \]\[ P = 60 \times 3.9927 + 1{,}000 \times 0.6806 = 239.56 + 680.58 = \$920.15 \]

The bond trades at a discount because the coupon rate (6%) is below the market yield (8%).

The Price-Yield Relationship

Bond prices and yields move inversely. When market interest rates rise, existing bonds paying lower coupons become less attractive; their prices fall until the yield rises to match the new market rate. This inverse relationship is not linear but convex: prices fall less for a given yield increase than they rise for the same yield decrease.

Duration: A measure of a bond's interest rate sensitivity, expressed as the weighted average time to receive the bond's cash flows. A bond with longer duration experiences larger price changes for a given change in yield. \[ D = \frac{\sum_{t=1}^{n} t \cdot PV(C_t)}{P} \]

Yield Measures

Current yield = Annual coupon / Current price. This ignores capital gains/losses at maturity.

Yield to maturity (YTM) is the discount rate that equates the present value of all future cash flows to the current market price. It assumes coupons are reinvested at the same rate.

Yield to call (YTC) applies to callable bonds: the yield assuming the issuer calls the bond at the first call date.

Credit Risk and Ratings

Corporate bonds carry default risk — the possibility the issuer cannot make promised payments. Rating agencies (Moody’s, S&P, DBRS Morningstar in Canada) assign credit ratings from AAA/Aaa (highest quality) through investment grade (BBB-/Baa3 and above) to speculative grade (“junk”) below. The credit spread (the yield premium above a comparable government bond) compensates investors for default risk.

Chapter 6: Financial Assets — Pooled Investments and Derivatives

Mutual Funds and ETFs

Open-end mutual funds continuously issue and redeem units at NAV. They are priced once daily after market close. Management Expense Ratios (MERs) in Canada can range from near zero for passive index funds to over 2.5% for actively managed equity funds — these fees are a significant drag on long-run returns.

ETFs offer intraday trading, typically lower fees, and tax efficiency. The ETF structure includes an authorized participant (AP) mechanism: large institutional investors can create or redeem large blocks of ETF shares (called creation units) by exchanging a basket of underlying securities. This arbitrage mechanism keeps the ETF’s market price close to its NAV.

Introduction to Derivatives

A call option gives the holder the right (but not obligation) to buy the underlying asset at the strike price $K$ before or at expiry. At expiry:

\[ Payoff_{call} = \max(S_T - K, 0) \]

A put option gives the holder the right to sell:

\[ Payoff_{put} = \max(K - S_T, 0) \]

where $S_T$ is the asset price at expiry.

Futures contracts obligate both parties. A long futures position profits when the asset price rises above the futures price; a short position profits when prices fall.

Chapter 7: Market Efficiency

The Efficient Market Hypothesis

The Efficient Market Hypothesis (EMH) holds that asset prices fully and immediately reflect all available information. If markets are efficient, no investor can consistently earn abnormal returns (returns above those justified by risk) through analysis of available information.

Market efficiency: A market is efficient with respect to an information set if it is impossible to consistently generate excess returns by trading on that information.

Forms of the EMH

Weak-form efficiency: Prices fully reflect all past trading information (historical prices, volume). Technical analysis — the search for patterns in past prices — cannot generate abnormal returns in a weak-form efficient market.

Semi-strong-form efficiency: Prices fully reflect all publicly available information (financial statements, earnings announcements, macro data). Fundamental analysis cannot generate abnormal returns if this form holds.

Strong-form efficiency: Prices reflect all information, including private (inside) information. Even insiders cannot consistently profit. This extreme form almost certainly does not hold, which is why insider trading regulations exist.

Evidence For and Against Efficiency

Supporting evidence: Professional mutual fund managers, on average, fail to outperform passive index funds after fees. Most technical trading rules do not generate persistent risk-adjusted profits. Event studies show that prices react rapidly and apparently correctly to announcements.

Challenging evidence (anomalies):

Momentum effect: Stocks that have performed well over the past 6–12 months tend to continue outperforming over the next 6–12 months (Jegadeesh and Titman, 1993).
Value premium: Low P/B (“value”) stocks have historically outperformed high P/B (“growth”) stocks.
January effect: Small-cap stocks have historically generated anomalously high returns in January.
Post-earnings announcement drift: Stock prices continue drifting in the direction of an earnings surprise for weeks after the announcement.

Behavioural finance researchers (Shiller, Thaler, Kahneman) argue that systematic cognitive biases — overconfidence, loss aversion, anchoring, herding — cause predictable mispricings. Markets may be efficient in the long run even if short-run deviations exist.

Implications for Investors

If markets are efficient, active management cannot consistently add value net of fees. Passive index investing offers market returns at minimal cost. The relevant question for an investor is not “which stocks to pick?” but “what level of risk is appropriate, and how should I diversify?”.

Chapter 8: Course Integration — Financial Decisions in a Global Context

Portfolio Construction and Diversification

Diversification reduces risk by combining assets whose returns are not perfectly correlated. The variance of a two-asset portfolio is:

\[ \sigma_p^2 = w_1^2 \sigma_1^2 + w_2^2 \sigma_2^2 + 2 w_1 w_2 \sigma_1 \sigma_2 \rho_{12} \]

where $w_i$ are weights, $\sigma_i^2$ are variances, and $\rho_{12}$ is the correlation coefficient. When $\rho_{12} < 1$, diversification reduces portfolio variance below the weighted average of individual variances.

Systematic (market) risk cannot be diversified away — it reflects macroeconomic fluctuations that affect all assets. Unsystematic (idiosyncratic) risk is eliminated through diversification. The Capital Asset Pricing Model (CAPM) states that only systematic risk is rewarded:

\[ E(r_i) = r_f + \beta_i \left[ E(r_m) - r_f \right] \]

where $r_f$ is the risk-free rate, $E(r_m) - r_f$ is the equity risk premium, and $\beta_i$ measures the asset’s sensitivity to market returns.

The Canadian Financial Landscape

Canada’s financial system is dominated by the “Big Six” banks: Royal Bank, Toronto-Dominion, Bank of Nova Scotia, Bank of Montreal, CIBC, and National Bank. The TSX and TSX Venture Exchange are the primary equity markets. The Bank of Canada sets monetary policy, targeting 2% CPI inflation, and acts as lender of last resort. The federal government issues bonds through the Bank of Canada’s auction system.

International Dimensions

Global capital flows dwarf domestic flows in many countries. Canadian investors benefit from diversifying internationally across markets with different economic cycles, industries, and risk profiles. Currency risk — the variability of returns introduced by exchange rate fluctuations — must be managed or accepted. Hedging with currency forwards or options can neutralize exchange rate exposure, but at a cost.

Cross-listing occurs when a firm’s shares trade on more than one national exchange, improving liquidity and access to foreign capital. Many large Canadian companies (e.g., Canadian Pacific, Shopify) list on both the TSX and NYSE.