Problem:
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.