Final answer:
The required return on a bond is equal to the real rate of return plus a risk premium plus an expected inflation premium, accounting for delaying consumption, inflationary adjustments, and borrower's riskiness. correct answer is option 1.
Step-by-step explanation:
An investor who buys a bond expects to receive a rate of return. The required return on a bond reflects the compensation investors demand for the different types of risks they face. We can break down the return into three key components:
- Real rate of return: This serves as compensation for delaying consumption.
- Expected inflation premium: This adjusts for an inflationary rise in the overall level of prices.
- Risk premium: This accounts for the risk associated with the borrower's capacity to repay the bond, also referred to as default risk, and includes other types of risk like interest rate risk.
Therefore, the correct answer to the student's question is that the required return on a bond is equal to the real rate of return plus a risk premium plus an expected inflation premium, aligning with option 1).