Final answer:
The expected return on junk bonds includes a risk premium due to the high risk of default, which compensates lenders for the potential losses that might occur if the borrower cannot repay. The yield reflects all expected returns, encompassing risk premium and compensation for inflation and delaying consumption.
Step-by-step explanation:
The expected return on junk bonds includes a risk premium because the lender might not be paid back. Junk bonds offer a high rate of return but also carry a relatively high chance of defaulting on the payments, which represents the compensation for potential losses the investor may face due to borrower's inability to pay back. These bonds are therefore associated with a higher risk premium over safer investment options.
An interest rate can be divided into three components: compensation for delaying consumption, an adjustment for inflation, and a risk premium based on the borrower's riskiness. In the case of junk bonds, the risk premium is significant because of the borrower's heightened risk of default. This risk premium is included in the bond's yield, which is the promised rate of return at the time of purchase.
The posted yield on a bond encapsulates all expected returns, including compensation for the risk faced. Thus, the answer to the question is that the expected return on junk bonds includes a risk premium because the lender might not be paid back, making option (e) the correct choice.