An Interpretation of Interest Rates Variability in Dealer´s Model of Optimal Interest Margin

The paper deals with interest rate volatility interpretation in the dealer´s model of optimal interest margin. It defines main sources of interest rate volatility and studies how specific source of volatility influences optimal interest margin. Special attention is focused on unexpected shock in liquidity of banking system, actual central bank´s decision on targeted level of interest rate, long-term deviation of inflation and output from central bank´s targeted values and potential impact of these factors on term premium instability. Sources of interest rates are discussed in term of bank´s refinancing/reinvestment risk with an attempt to formalize interest rate volatility for further empirical research. Our conclusion is that dealer´s model of optimal interest margin is consistent with only permanent shocks to banking system liquidity and long-lasting central bank´s surprises with its monetary policy that increase a level of refinancing/reinvestment risk faced up by banks. On the other hand it is not consistent with interest rate volatility caused by transitory liquidity shocks, expected current changes in central bank´s targeted main policy rate and long run trends in main policy rate based on disinflation.