Module 10 · Chapters 15, 16, 17

Expectations & Asset Prices

Bonds, stocks, and the present-value reading of the economy.

“Where today's actions are priced by tomorrow's expectations.”

~35 min· 4 sub-skills·5 exercises0% mastered

Almost every macro variable that moves markets is forward-looking. Bond yields embed expected future short rates; stock prices embed expected future dividends; consumption depends on expected future income. This module gives you the discounted-present-value lens.
Discounted present value
$PV \;=\; \sum_{t=0}^{T} \frac{X_t}{(1+r)^t}$
$X_t$
cash flow at date t
$r$
(real or nominal) discount rate
Future cash flows are worth less today; the further out, the steeper the discount.
Term structure (expectations hypothesis)
$(1 + i_{nT})^T \;=\; (1 + i_{n1,t}) \cdot (1 + i^e_{n1,t+1}) \cdots (1 + i^e_{n1,t+T-1})$
T-period yield is the geometric mean of expected one-period rates. An inverted curve = markets expect rate cuts.
Gordon growth (constant-growth dividends)
$P_0 \;=\; \frac{D_1}{r - g}$
$D_1$
next-period dividend
$r$
required return
$g$
constant dividend growth, g < r
Higher r (rate hike) lowers P. Higher expected g raises P. The most-cited identity in equity research.
Figure · Yield curve: normal, flat, inverted
Yield curve · Normal — long > short.
Inverted yield curves have preceded almost every US recession since 1970.
Definition·Permanent income hypothesis (Friedman)
Households smooth consumption over expected lifetime income, not current income. A windfall is mostly saved; a permanent income increase is mostly spent. The MPC out of transitory income is small; out of permanent income, near 1.
Common misconception
Lower interest rates always raise stock prices.
ActuallyUsually yes (lower r in Gordon). But when rate cuts signal a recession that lowers expected g, stocks can fall on the news. Empirically: 'bad-news-is-good-news' regimes vs. 'bad-news-is-bad-news' regimes.
Exercise · numerical · +12 XP
PV of a 3-year stream
Cash flows: 100 in year 1, 100 in year 2, 100 in year 3. r = 5%. PV?
Your answer (EUR (today's value))
Exercise · numerical · +10 XP
PV of a perpetuity
Annual coupon 50 forever, r = 4%. PV?
Your answer
Exercise · numerical · +14 XP
2-year yield from expected 1-year rates
i₁ = 3% today; market expects next year's 1-year rate to be 5%. What is the 2-year yield (geometric average)?
Your answer (% per year)
Exercise · numerical · +12 XP
Gordon growth
D₁ = 4, r = 8%, g = 3%. Compute P₀.
Your answer
Exercise · multiple choice · +10 XP
Transitory vs permanent
A household receives a one-time €1,000 windfall. Under PIH, how much do they consume in the year of receipt (assume 30-year horizon, r ≈ 0)?

Mastery check

5 questions · pass with 80%

Answer all five to confirm you've internalised the module. A passing run unlocks the next module.

Q1
"Higher discount rate r raises the present value of future cash flows."
Q2
An inverted yield curve (long < short) typically signals:
Q3
In Gordon growth, P₀ = D₁/(r−g). What raises P₀?
Q4
"Under PIH, the MPC out of permanent income is approximately 1."
Q5
Coupon 100, r = 5%. Perpetuity PV?

0 / 5 answered

Exam pitfalls

Confusing nominal and real cash flows when discounting. Match: nominal X with nominal r, real X with real r.
Forgetting g < r in Gordon growth. If g ≥ r, the formula explodes — use a multi-stage model.
Treating yields as additive when computing the term structure. Geometric average, not arithmetic.
Mixing up the inverse: high price → low yield (and vice versa).