INTRODUCTION
This case study is a perfect example of arbitrage and pricing differentials in the securities market. The case highlights the twin companies of Royal Dutch Shell Group, which is one of the largest oil companies in the world and also one of the largest among the European. This twin Group was created as a result of a merger between two companies; England’s Shell and Royal Dutch of the Netherlands. The case looks from the perspective of an institutional investor on the various price differentials that the various equity listings of both these companies are showing. It is also presented in the light of a hedge fund, which is seeking to hedge the differing risk and get an arbitrage opportunity.
CASE ANALYSIS
The case discusses the various reasons behind the price differentials which are quite large looking at the liquidity and scale of the stocks. These reasons include the different tax treatment in different geographical markets, etc. However, all these reasons fail to provide a satisfactory answer to the price differentials. The following analysis of the case shows the various areas in which reason of these differentials in prices is questioned.
1-Describe the structure of Royal Dutch/Shell Group. Does it differ from the equity listings of other companies that you know?
As shown in the Exhibit 2 of the case, the ownership and structure of the Royal Dutch/Shell Group is looked into to get an idea about its structure and its possible effect on the price differentials. It is quite clear that the separation of both companies exists only on the holding company level and other all operational aspects of the company are affected by the 60/40 ratio that is owned by both holding vehicles.
It can be debated that there are some factors which make the separation of the two companies look practically impossible. Like, the name Shell is being used as a brand name for each of the operating companies. Furthermore, the corporate structure of the company which is being integrated for over a century cannot be unwound and put off showing its connection with each other. This structure evidently shows that there is one company which is being run by two different classes of equity listings rather than being two joint venture companies run by separate entities. It shows that the price differentials cannot be explained by the difference in the structure of the two companies. The prices of the equivalent shares in both holding companies because of the 60/40 split rule, should not deviate from this rule.
2-What are ADRs? Why might companies find it attractive to issue ADRs? Why would investors be interested in this method of raising equity capital?
The ADRs or American Depository Receipts are the equivalent equity certificates which are issued and traded in the United States exchange to be exchanged with the shares of a foreign company held in a depository bank. Naturally, it means that it allows the non-US companies to have access to the US markets without being listed in their exchanges. It benefits the foreign companies by skipping the lengthy approval process for listing on US exchanges. Furthermore, these markets also use the same clearance channels and US settlements as the domestic securities, making it convenient for the customers in the US.
This security also aids the large multinational companies who are operating in developing countries to get access to the international equity markets without getting into significant approval processes when they are unable to get significant capital from the local markets, which are too small for these large corporations.
3-Identify price differentials between different equity listings of the Royal Dutch/Shell Group. How can they be explained? What percentage of the particular price differentials you identified can be due to the explanations you suggested?
The main point of all the cases is the constant price differentials which are being questioned. The price differentials here are two types. There is a price differential which is constituted from the difference of the holding companies. Moreover, then there is also another price differential which s arising from the change in the geographic market.
The table below shows the price differential of one market to another as well as to another holding company. By analyzing the table below the following points is evident regarding the price differential:
| Shell London | Shell ADR NYK | Royal Dutch Amsterdam | Royal Dutch NYK | |
| Shell London | 0 | -1.84% | -12.13% | -12.13% |
| Shell ADR NYK | 1.88% | 0.00% | -10.48% | -10.48% |
| Royal Dutch Amsterdam | 13.80% | 11.71% | 0.00% | 0.00% |
| Royal Dutch NYK | 13.81% | 11.71% | 0.00% | 0.00% |
- Shell is trading at significant discount to the Royal Dutch Company.
- Europe seems to also offer a significant discount to the New York Market.
It is evident on a historical basis that the geographical price differentials are more significant as compared to the company difference.
The potential reason of price differential can be attributed to the difference in the ownership of both holding companies. It can lead to the different tax treatments because of being under different jurisdictions. It is discussed that the investors in the Pension Fund face different treatment of tax in either jurisdiction.
The effects of these treatments are shown in the exhibit 11. The calculations show that the discrepancies attribute to the very small range, nearly about 1% of the value of the company. Other than this, the difference in the administrative and operative vehicles of the two companies also makes it deviate from the 60/40 rule. Moreover, the deviation because of the difference in the currency denomination of the paid dividends can also be an explanation for the differential. However, the case explains and shows that the proposed explanations are not the reasons for the price differential between the two holding companies.
4-Is there an arbitrage opportunity in the price differentials you identified? What kind of arbitrage transactions would you propose to exploit these opportunities?
There are the variety of options and alternatives through which one can take advantage of the arbitrage opportunity. Buy/Sell can be one option through which an investor can liquidate its shares of Royal Dutch and then purchase an equal share stake in Shell. Following the, it can be further sold back, and the Royal Dutch share can be purchased back.
| New York: | ||
| Spread | 25 | c per share |
| Commission | 10 | c per share |
| Total | 35 | bps |
| Shell (London) | ||
| Spread | 35 | bps =0.03/8.63 |
| Commission | 60 | 2x 30 bps |
| FX spread | 50 | Conv. Of $ to GBP to $ |
| Stamp Tax | 6 | UK Stamp tax |
| Total | 151 | bps of the total amount of trans. |
| Royal Dutch | ||
| Spread | 13 | DG 0.3/227.8 |
| Commission | 60 | 2x 30 bps |
| FX spread | 6 | bps |
| Total | 79 | bps of the total amount of trans. |
For this option, HSGA can sell the shares in NY and the purchase Shell shares in London. The cost of the transaction would be 25c cost x 395088 shares plus $50m x 151bps in London, resulting in $853772 of cost.
Another option can be to use Buy/Short Option. For this HSGA can borrow the RD shares and then sell it. Then it can invest the earnings and pay the 40bps commission to the lender. Then it can purchase back RD shares and return these shares back to its lender. For this, 75 bps over LIBOR is assumed as a cost.
It will result in selling short of Royal shares in Europe and purchasing back of Shell in Europe. Cost of transaction will be 56mx73 bps + 50mx 151bps = 1.22 million. The 40 bps on 56 m and 75 bps to 50 m are the holding costs. The interest earned would be on the difference of 6 million assumed at 5%, with #300000 per year.
Another alternative is the use of swap. It would not incur any direct transaction costs; however, 4% of 50 million will be paid.
5-Calculate the net payoffs of the arbitrage transactions you suggested. Can such transactions enforce market discipline?
The net payoffs from these transaction alternatives are computed as follows:
| Arbitrage Method | Transaction Costs | Cost of Holding | Interest Income | Convergence |
| Buy/Sell | $ 853,772 | $ – | $ 29,950 | $ 3,146,228 |
| Swap | $ – | $ 2,000,000 | $ – | $ 4,000,000 |
| Buy/Short | $ 1,163,800 | $ 224,000 | $ 29,950 | $ 2,836,200 |
It shows that whatever strategy can be adopted if the prices are seen converging, the HSGA will earn a definite profit. Moreover, the swap alternative looks the most attractive as it earns the highest profit.
Assuming discounting for the three-year case, and 66% differential in the first two cases, the discipline table is presented as:
| Arbitrage Method | Convergence | Convergence in 3 Yrs | No Convergence | Perpetuity CF (in M) |
| Buy/Sell | $ 3,146,228.00 | $ 4,046,228.00 | $ 5,146,228.00 | $ 6.00 |
| Swap | $ 4,000,000.00 | $(2,000,000.00) | $ (4,000,000.00) | $ (40.00) |
| Buy/Short | $ 2,836,200.00 | $ 1,936,200.00 | $ (7,163,800.00) | $ (6.00) |
The above discipline table shows that within an immediate convergence period, the swap option is the most attractive. However, as the convergence period lengthens to three year period, Swap becomes the least attractive option. It shows that the market analysts can be reluctant in the exploitation of this arbitrage opportunity as it incurs losses in the long and short run periodically, and market discipline is missing in this scenario.
(OPTIONAL) 6. By your analysis and the findings presented in the case, what other suggestions would you propose to explain the observed phenomena? To what extent can they provide a satisfactory answer?
The strategy of buy/sell is only preferable for the ones who are currently holding the shares of Royal Dutch. The HSGA investment fund is one of those and can gain from this strategy. Even from this, the profits may not be entirely attractive to the institutional investor as any divergence from the assumption would cost in the form of losses. The buy/Short option is also only profitable in the case of fast convergence, and swaps, which seem to be the more profitable, are showing the least profits in the long term. It shows that if interested, it is suggested to use Buy/Sell or Buy/Short alternative to gain any arbitrage opportunity in case of immediate convergence.
CONCLUSION
It is concluded that the investors might be reluctant in going for the arbitrage opportunity, as it incurs losses in the long and the short run period. It is also evident because the market discipline is missing in this scenario.
With the above case analysis, it shows that as the convergence period is extended to three year period or perpetual cash flows, Swap becomes the most losing option, however, within an immediate convergence period; the swap option is the most attractive. Moreover, all the proposed explanations for the price differential cannot be accounted for it, as it does not show any relative behavior.
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