Risk-Free Rate in the Covid-19 Pandemic: Application Mistakes and Conclusions for Traders

TL;DR

This paper highlights how traders often incorrectly lower the risk-free rate during crises like Covid-19, leading to flawed investment decisions and misapplications of financial models.

Contribution

It identifies a common mistake in setting the risk-free rate during crises and discusses its impact on financial modeling and decision-making.

Findings

Traders tend to undercut the risk-free rate during crises.

This mistake affects CAPM, option pricing, and portfolio decisions.

Incorrect risk-free rate assumptions lead to flawed financial strategies.

Abstract

This short paper is intended to demonstrate a crucial omission made by traders in setting the risk-free interest rate, especially in times of crisis: instead of increasing the risk-free rate, traders undercut it en masse on the contrary. This results in incorrect investment and financial decisions, especially those involving CAPM models, option pricing models and portfolio theory.