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Forecasted Interest Rates with Premiums

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Please help with the following problem and show all the work so that I may fully understand the concept of the problem.

You have been asked to forecast interest rates for the next 5 years. You have been given the following estimates:

The risk free rate is expected to have a 30% of being 2%, a 20% chance of being 1.5%, a 20% of being 2.5% a 15% of being 2.75% a 10% chance of being 3% and a 5% chance of being 3.25%.

Inflation is expected to be 2% next year, 2.5% for the following 2 years and 3% for years 4 and 5.

You have been told to use .008% as the liquidity premium, .1(t-1) % as the maturity premium and 1.1% as the default premium.

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Solution Summary

This solution is comprised of a detailed, step-by-step calculation of the forecasted interest rate for a given period.

Solution Preview

We will first find the expected risk-free rate.

Risk-free rate Probability
2% 0.3
1.5% 0.2
2.5% ...

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