Final answer:
The inflation premium compensates for the erosion of purchasing power due to inflation, and it's included in the interest rate to ensure the investor's returns are not diminished over time by rising prices.
Step-by-step explanation:
The inflation premium is the additional return demanded by investors to compensate for the adjustment for an inflationary rise in the overall level of prices. Therefore, the correct answer to the student's question is a) Inflation. Investors expect a rate of return that factors in different components: compensation for delaying consumption, an inflation adjustment, which is the inflation premium itself, and a risk premium reflecting the borrower's creditworthiness.
An example is when a financial investor chooses an interest rate that reflects not only the opportunity cost of investing capital but also includes a risk premium if the investment is seen as risky. In essence, the inflation premium compensates for the decrease in purchasing power associated with future cash flows due to inflation.