Final answer:
The required rate of return on an investment includes the real rate of interest, expected inflation, and risk. These components compensate for delayed consumption, inflation adjustments, and riskiness of the borrower.
Step-by-step explanation:
The required rate of return is comprised of all of the above: the real (risk-free) rate of interest, expected inflation, and risk. When an investor buys a bond, they anticipate a return on their investment, which can be broken down into these three components:
- Compensation for delaying consumption
- Adjustment for an inflationary rise in the overall level of prices
- Risk premium that accounts for the riskiness of the borrower
Together, these factors determine the rate of return an investor requires to compensate for the time value of money, changing price levels due to inflation, and the uncertainty inherent in lending to a particular borrower.