Investing in Royal Dutch and Shell: A Case Study on Arbitrage Opportunities

The global investment management organization High Street Global Advisors is investigating the potential opportunities presented by the pricing discrepancy between Royal Dutch and Shell. This case study explores the advantages of investing in the shares of these two related companies. Royal Dutch sees higher trading activity in the Netherlands and U.S. markets, while Shell is more active in the United States. The discrepancy in stock prices between these twin equities, which are listed on different European stock markets, creates arbitrage opportunities for investors.

For instance, a U.S. (Dutch) investor can purchase Royal Dutch and Shell in New York (Amsterdam). Question 1:

Royal Dutch Petroleum and Shell Transport and Trading are the parent companies, holding the highest position in their organizational structure. The Royal Dutch and Shell Group of companies originated from a 1907 deal, with shares held by the Group Holding Companies at a split ratio of 60% and 40%. Their share price is fixed proportionally. One notable feature distinguishing them from other companies is their joint operation despite being from different countries.

Get quality help now

Prof. Finch

Verified writer

Proficient in: Economics

4.7 (346)

“ This writer never make an mistake for me always deliver long before due date. Am telling you man this writer is absolutely the best. ”

+84 relevant experts are online

Hire writer

Collaboration between the entities is a key aspect of Royal Dutch and Shell. Essentially, while they are distinct entities, Royal Dutch and Shell have their stocks traded together at a split ratio of 60% and 40%.

ADRs, also known as American Depositary Receipts, were created in 1927 to allow US investors to buy foreign equity securities that have been converted into American assets. ADR holders purchase and receive dividends in dollars, with corporate actions communicated in English. These stocks trade like regular US stocks and are typically issued or sponsored by a bank or brokerage firm.

ADRs simplify the process of investing in foreign markets and trading complexities. US banks often acquire shares from foreign companies, bundle them together, and reissue them on exchanges like NYSE or AMEX. In return for this service, the foreign company must provide detailed financial information to the sponsoring bank.

The depositary bank determines the ratio of U.S. ADRs to home-country shares, which can be greater or less than 1. This balancing act is aimed at pricing the ADR high enough to demonstrate value, yet low enough to be accessible to individual investors. Most investors prefer to steer clear of penny stocks and would likely avoid a company with shares priced at 50 Russian roubles, equivalent to US$1.50. Consequently, the majority of ADRs usually fall within the $10 to $100 per share range. In cases where home-country shares are worth significantly less, each ADR may represent multiple actual shares. There are three main types of ADR issues:

Level 1 ADRs are the most basic type of ADR, typically not listed on an exchange but found on the over-the-counter market. They offer a simple and cost-effective way for foreign companies to gauge interest in their securities in North America, with minimal requirements from the SEC. Level 2 ADRs, on the other hand, are listed on an exchange or quoted on Nasdaq, providing higher visibility and trading volume with slightly more SEC requirements. The most prestigious type is Level 3 ADRs, where an issuer floats a public offering of ADRs on a U.S. exchange to raise capital and gain substantial visibility in U.S. financial markets. Companies may find issuing ADRs attractive for these reasons.

To expand their shareholder base, companies acknowledge the importance of US shareholders and seek to create a convenient platform for them through ADRs. ADRs offer advantages to both individuals and foreign entities. For individuals, ADRs provide a simple and cost-effective way to invest in foreign companies, saving money on administration costs and foreign taxes. Foreign entities benefit from increased exposure to the US equities market. Investors are attracted to the transparency and ease of raising equity capital through ADRs, as it allows for seamless transfer of equity exposures and money in dollars without processing hassles, thus creating more diversified stock options.

Creates greater global stocks/equity. Banks create a deposited agreement which allows the security to be available in the US and traded freely by US investors. There are various risks involved, including political risk (related to the instability of the home country issuing ADRs), exchange rate risk (as ADR shares track shares in the home country and can be affected by currency devaluation), and inflationary risk (resulting from rising prices and falling purchasing power). All of these risks can impact ADRs and lead to potential losses even for companies performing well.

Royal Dutch prices are typically higher than Shell prices because it is part of the S&P 500, even though it is not a US company. The strong performance of the S&P 500 in 1995 resulted in an uptick in Royal Dutch prices. Furthermore, tax advantages for pension funds in both the US and the Netherlands add to the appeal of Royal Dutch shares. Investors in these countries can benefit from tax-free investments when choosing to invest in Royal Dutch.

The security prices for Royal Dutch and Shell differ between Europe and New York. In Europe, the price for Royal Dutch is $141.368 and for Shell it is $124.222, while in New York, the prices are $141.375 for Royal Dutch and $126.554 for Shell. This indicates that prices in Europe are higher than in New York. By dividing the equivalent prices of Royal Dutch and Shell, it shows a premium of 13.80% in Europe and 11.71% in New York, meaning that the price of Royal Dutch is 13.8% higher than Shell in Europe and 11.71% higher in New York.

Arbitrage opportunities occur due to price discrepancies, which can be leveraged by taking advantage of geographical differences between Royal Dutch and Shell stocks. One method is purchasing shares in a market with lower prices and selling them in a market with higher prices, like buying in New York and selling in Amsterdam. However, it is important to consider factors such as bid-offer spread when conducting these transactions.

It is important to consider that bid-ask spreads can vary depending on the quantity and market. For example, the selling price of Royal Dutch and Shell ADRs on the NYSE may fluctuate by up to 25 cents. Additionally, commission fees for traders can differ in pricing and calculation methods across markets. Taxation regulations also vary, leading to different tax payments when trading securities in different markets. Currency conversion should also be taken into account as exchange rate discrepancies will affect transactions. Following the recommendations outlined in the case study, it may be strategic to hold onto Shell stocks for a longer period while quickly buying/selling Royal Dutch stocks due to their higher and lower prices respectively.

In the long run, prices will attempt to reach parity, which is the goal of management. To achieve this, Royal Dutch stock prices may decrease while Shell prices may increase. By selling Royal Dutch at a higher price and buying back at a lower price, money can be made. Conversely, holding onto Shell for an extended period may lead to gains as prices rise to reach parity. Additionally, High Street Global Advisors will engage in a privately negotiated total return swap with a Wall Street Firm to trade international stocks. High Street Partners will receive returns on Shell ADRs held by the firm, while the Wall Street Firm will receive returns on Royal Dutch shares held by High Street.

The swap involves exchanging 610,867 Shell ADRs from Wall Street Firm for 395,088 shares of Royal Dutch from High Street Partners. Each Shell ADR is valued at $81.875 per share, making a total market value of $50 million, while each Royal Dutch share is priced at $141.375, resulting in a market value close to $55.85 million. Additionally, High Street Partners will need to pay 4% per annum on the $50 million to Wall Street Firm. The swap will involve Wall Street Firm paying High Street Partners the total dollar return on the Shell ADRs, and High Street Partners paying Wall Street Firm 4% per annum on the $50 million plus the total dollar return on the Royal Dutch shares. To make money, Royal Dutch will earn the difference between the return on the Shell ADRs and paying Wall Street Firm 4% on $50 million, as well as giving a return on their own Royal Dutch shares.