12. Whether such local cheapness effects appear as deviations from a fitted yield-curve or as “wiggles” or “kinks” in the fitted curve depends on the curve-estimation technique. Recall that all curve-estimation techniques try to fit bond prices well while keeping the curve reasonably shaped. If the goodness of fit is heavily weighted, all bonds have small or no deviations from the fitted curve. However, a close fit may lead to “unreasonably” jagged forward-rate curves. Based on Eq. (37–2), the forward-rate curve should be smooth rather than jagged because maturity-specific expectations of rate or volatility behavior are hard to justify and because arbitrageurs presumably are quick to exploit any abnormally large expected-return differentials between adjacent-maturity bonds.

13. In our analysis we include the local effects into the expected bond returns separately as a fifth term. As an alternative, we could include the financing advantage (repo income) and the spread off the curve in the yield income, and we could include the expected cheapening in the roll-down return. “Rich” bonds, such as the on-the-runs, are unlikely to roll down the fitted curve if the overall curve remains unchanged. More likely, they eventually will lose their relative richness. It may be reasonable to assume that an on-the-run bond’s yield advantage and expected cheapening roughly offset its expected financing advantage. For other issues than on-the-runs, it is often reasonable to assume (or better, estimate) some reversal toward the issue’s “normal” cheapness spread versus the fitted curve.

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