High Street Global Advisors, a global investment management organization is trying to understand the opportunities presented by the Royal Dutch/Shell pricing discrepancy. This case analyzes the benefits of shares of two twin companies Royal Dutch and Shell. Royal Dutch trades are more actively in the Netherlands and U.S. markets, whereas Shell trades are more actively in the United States. They are getting price benefit mainly from arbitrage opportunities arising from daily stock price difference between the prices of twin equities that cross-listed in different European stock markets. For example, a U.S. (Dutch) investor can buy Royal Dutch and Shell in New York (Amsterdam). Question 1:
Two parent companies- Royal Dutch Petroleum and Shell Transport and Trading position in the highest hierarchy in their organizational structure. The Royal Dutch and Shell Group of companies have just started from the 1907 deal. Their shares are held by the Group Holding Companies, which trade at a defined split- 60% and 40%. Additionally their share price is proportionally fixed. Its distinguished feature from most of the other companies is the joint operation of two companies which they represent two different countries. Cooperation between entities is one of the distinguished features of Royal Dutch and Shell. To sum up, we can conclude Royal Dutch and Shell equity firm as different entities, but their stocks are traded together, even at a split of 60% and 40%. Question 2:
American Depositary Receipts (ADRs)
ADRs was Introduced to the financial markets in 1927 and it Is a foreign equity security that has been Americanized or wrapped in such a way, that allows American investors to purchase foreign equities in the United States, investors purchase in dollars and their all dividends are received in dollars and corporate actions are in English which really Americanize foreign equity from multiple countries around the world. In another word, (ADR) is a stock that trades in the United States and ADRs are bought and sold on American markets just like regular stocks and are issued/sponsored in the U.S. by a bank or brokerage. ADRs were introduced as a result of the complexities involved in buying shares in foreign countries and the difficulties associated with trading at different prices and currency values. For this reason, U.S. banks simply purchase a bulk lot of shares from the company, bundle the shares into groups, and reissues them on either the New York Stock Exchange (NYSE), American Stock Exchange(AMEX) and etc In return, the foreign company must provide detailed financial information to the sponsor bank.
The depositary bank sets the ratio of U.S. ADRs per home-country share. This ratio can be anything less than or greater than 1. This is done because the banks wish to price an ADR high enough to show substantial value, yet low enough to make it affordable for individual investors. Most investors try to avoid investing in penny stocks, and many would shy away from a company trading for 50 Russian roubles per share, which equates to US$1.50 per share. As a result, the majority of ADRs range between $10 and $100 per share. If, in the home country, the shares were worth considerably less, then each ADR would represent several real shares. There are three different types of ADR issues:
Level 1 – This is the most basic type of ADR where foreign companies either don’t qualify or don’t wish to have their ADR listed on an exchange. Level 1 ADRs are found on the over-the-counter market and are an easy and inexpensive way to gauge interest for its securities in North America. Level 1 ADRs also have the loosest requirements from the Securities and Exchange Commission (SEC). Level 2 – This type of ADR is listed on an exchange or quoted on National Association of Securities Dealers Automated Quotation (Nasdaq). Level 2 ADRs have slightly more requirements from the SEC, but they also get higher visibility trading volume. Level 3 – The most prestigious of the three, this is when an issuer floats a public of ADRs on a U.S. exchange. Level 3 ADRs are able to raise capital and gain substantial visibility in the U.S. financial markets. Why companies might find it attractive to issue ADRs?
To expand their share holder base
To acknowledge that US share holders are important to them and to create a vehicle that makes it easy for them to hold, trade and settle those securities, The advantages of ADRs are twofold. For individuals, ADRs are an easy and cost-effective way to buy shares in a foreign company. They save money by reducing administration costs and avoiding foreign taxes on each transaction. Foreign entities like ADRs because they get more U.S. exposure, allowing them to tap into the wealthy North American equities markets. Why would investors be interested in the method of raising equity capital? From an investors point of view it’s more transparent, equity exposures are transferred to English and money is transferred in dollars without much of processing troubles. It creates more poles of stocks.
Creates greater global stocks/equity.
Banks Create a deposited agreement which would make the security available in the US and that security become freely tradable for US investors. Risks, Political Risk: The instability of home country who issues ADR affects the ADRs. Exchange Rate Risk: as we know that ADR shares track the shares in the home country and if a country’s currency is devalued, it will trickle down the ADRs which can result in big loss, even the company had been performing well. Inflationary Risk – inflation is a stage which the general level prices of goods and services is rising and subsequently, purchasing power is falling in result the currency of country with high inflation becomes less valuable each day, which as we said in Exchange Rate Risk, it will trickle down the ADRs. Question 3:
Royal Dutch price is generally more expensive than Shell price. Because it was traded in S&P 500. It is considered as US company although it is not actually US company. S&P500 did very well in 1995 and that was also a reason for Royal Dutch prices to go up over time as it traded in S&P500. Other reason is because of the tax issues for pension funds in US and Netherland. They prefer Royal Dutch because they don’t have to pay any tax on those investments. In US they do not get any tax from pension funds investing in Royal Dutch shares. In Netherland it does it and it is logical, because it is based in Netherlands. They tell to pension funds that if you invest in Royal Dutch we are not going to get any tax from your investments which is while in US and in Netherlands people actually invest in those funds That is why the price of it is more attractive for those people as well.
It shows in Europe, security price for Royal Dutch is $141.368 and for Shell it It shows that in Europe the price of Royal Dutch is $141.368 and the price of the shell is $124.222. Then in New York, it is $141.375 for Royal Dutch and $126.554 for Shell. It means in Europe price is more than in New York .In 9th part it divides Royal Dutch to Shell equivalent price, to see how much premium it has. It has 13.80% premium in Europe and 11.71% premium in New York. It means that Royal Dutch price is 13.8% more than shell price in Europe and also 11.71% it is more than shell price in New York. Question 4:
Is there an arbitrage opportunity in the price differentials identified? What kind of arbitrage transactions would you propose to exploit these opportunities? Yes there are opportunities we could exploit in the price differentials between Royal Dutch and Shell as well as the geographic disparities among themselves (meaning geographic disparity in Royal Dutch shares & geographic disparity in Shell shares in different markets) First one would be about exploiting geographic disparity- meaning we can actually buy Dutch and Shell stocks in one market and sell in another. The logic with geographic disparity is that price difference of a stock on the same day in New York vs Amsterdam for instance may be so big that we can sell in New York and then buy in Amsterdam for a lower price and thus make profit. Although it seems quite easy in word, there are so many parts that have to do with it: The first has to do with bid-offer spread (meaning difference between the price you ask for as a seller of a stock and how much a buyer actually wants to buy for) in different trading market.
So we have to keep in mind that there are different bid-ask spread for different quantities and as well as different markets. For instance so we have to keep in mind that price we will want to sell might end up being + or – 25 cents on NYSE for both Royal Dutch and Shell ADRs. The second thing has to do with commission fees we have to pay to our traders-which vary both in price and calculation scheme from market to market. Thirdly taxation comes into play in different markets we will pay different taxes while dealing with these securities. Fourthly we have to take in consideration that we will have to convert currencies-so exchange rate difference will also play a role. Secondly, as suggested in the case what we can do would be hold on to Shell stocks for longer period and buy-and sell Royal Dutch stocks in short period. That is because Royal Dutch prices are higher and Shell prices are lower.
As prices will try to trade at parity (become the same) in the long run-which is what management is actually planning to do, here is what will happen: To reach a parity, Royal Dutch stock prices might become lower, so selling it now at a higher price and then re-purchase them at lower price, we will be able to make money. Because Shell prices will become relatively higher in the long run (to reach parity), holding on them for longer period will help us actually gain money. Thirdly, High Street Global Advisors would try privately negotiated total return swap. This is how it will work: They will deal with their Wall Street Firm (which actually helps them trade with international stocks) in this swap. For a 12 month period, The High Street Partners will get return on Shell ADRs (Wall Street Firm holds), and Wall Street firm will get the return on Royal Dutch shares (High Street holds).
The swap is taking place between 610,867 Shell ADRs of Wall Street Firm and 395,088 shares of Royal Dutch of High Street Partners. Each Shell ADR is trading at $81.875 per share so a gross total of $50 million market value while Royal Dutch is trading at 141.375 per share-which is close to $55.85 million of market value. However, High Street Partners will also have to pay Wall Street firm 4% per annum on $50 million dollars. The Wall street Firm will pay High Street total dollar return on 610,867 shares of Shell ADRs and High street Partners would pay the Wall Street firm 4% per annum on $50 million plus the total dollar return on 395,088 shares of Royal Dutch. How will Royal Dutch make money? They will make money by the difference between receiving the return on 610,867 shares of Shell ADRs and paying Wall Street FIrm 6% on $50 millions as well give the return on their Royal Dutch shares.