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Re: Global Equity Markets: The Case of Royal Dutch and Shell

Structure: The Royal Dutch/Shell Group is different because it appears that it is functioning as a single company instead of two separate companies. Yet, they are functioning as two separate companies. The Shell Company in the Netherlands, the Shell Company in the UK and the Shell Petroleum Company in the USA all appear to be maintaining their own identities in their respective countries. The Royal Dutch and Shell Company share equally in the Shell Company in the Netherlands, The Shell Company in the UK and the Shell Company in the U.S. They are not separate companies since they are linked by corporate charter. There is a separation of the two entities on the holding company level and all operational entities are a 60/40 owned by the two holding vehicles. The equity listings of the companies I am familiar with are more like a merger of two companies. In a merger, both companies would become one sharing everything that they own. The two listed organizations have entered into profitsharing agreements with each other, and equalizationratios exist to keep the economic performances of the two stocks linked to each other.

ADRs: An ADR is an American Depository Receipt which is a stock that trades in the United States but represents a specified number of shares in a foreign corporation. ADRs are bought and sold just like stocks through a bank or brokerage. Investors usually find it more convenient to own an ADR since ADRs allow easy comparison to securities of similar companies as well as access to price and trading information. Companies may find it attractive to issue ADRs if they want a significant amount of investors in a foreign market. ADRs are common among large corporations and allow companies to offer their stock without being listed on the U.S. stock exchange. ADRs are a way for company to expand their financial pool of investors and a way to attract foreign funds. It also allows companies to avoid some of the legal approval process by the SEC. Investors may shy away from buy foreign stocks but an ADR makes the process simple. ADRs are equivalent certificates traded in the U.S. and issued in exchange for the shares of foreign entity kept at a depository bank Companies that issue ADRs make their stock available to the U.S. market and investors and eliminate some of the barriers to acquiring foreign capital.

Price Differential: The price differential of Royal Dutch/Shell according to Exhibit 8 is Europe 13.80% and New York 11.71%. Shell trades at a significant discount to Royal Dutch and Europe offers a small discount .01% to New York. One reason for the price differential may be the taxes in the different countries. Exhibit 3 shows that Royal Dutch is owned mostly in the U.S. and in the Netherlands while Shell is owned mostly in the UK. The 60/40 split between Royal Dutch and Shell may be because of tax laws. The case mentioned that “pension funds sometimes faced tax asymmetries from with respect to the two stocks.” It went on to say that in the Netherlands pension funds were exempt from withholding taxes on Royal Dutch but not on Shell.

Another reason may be the differences in currency for the respective countries which would result in a difference in dividends. According to the case Exhibit 10 shows the difference between Royal Dutch and Shell ADR returns from New York. “The return differential was regressed on three indices and two exchange rates.” The table show the beta based on local currency.

Arbitrage Opportunities: Based on the price differentials I believe that there are arbitrage opportunities. One arbitrage transaction is to sell your stock in Royal Dutch and buy shares of Shell stock. The investor would then sell his/her shares of Shell stock and buy Royal Dutch. Another arbitrage transaction would be to short Royal Dutch stock. The investor would then buy Shell and eventually sell Shell and buy back Royal Dutch. Another arbitrage opportunity would be to enter into the swap agreement that was mentioned in the case in which you would exchange the total return on one instrument for the total return on another, plus or minus a fee, where the total return on an instrument is its price appreciation or loss during the holding period, plus interest or dividend income paid on the instrument during the holding period. The third option would be to enter into a swap with the Wall Street firm.

Net Payoffs: The case stated that the one way commission is 5cents per share. New York has a two way commission of 10 cents giving us a 25 cent commission. Shell (London) has 30 basis points for commission for small trades since we are going for a round trip the total basis points would be 60 plus the 50 basis points for the Stamp Tax. Shell was quoted a spread of .03 divided by 8.63 x 10,000equals 35 plus 03 plus 03 (going both ways gives us a total of 151 bps Royal Dutch (Amsterdam has a spread of 227.8 which is divided into .3 x 10000 giving us a 13 bps plus commission of 30 cents per share going both ways for a total of 60 cents per share and a FX spread of 06 (03 +03 ((down and back)) giving us a total of 79 per share.

Buy/Sell Option
The first arbitrage option will be 395,088 x 25 cents transaction cost =$98,772
You would then add the transaction cost in London $5000 x 151= $755,000
The total transaction cost for this would be $853,000.

Buy/Short Option
The second arbitrage opportunity would involve a transaction cost of:
$5600 of Royal Dutch x 73 in Amsterdam =$408,800
Plus $5000x151 (transaction cost in London) =$812,000
Total transaction cost $1.22 million

The third option of the sway would not involve any transaction cost. Based on the transaction costs alone I believe that the swap using the Wall Street firm is the most advantageous. In this case I believe that market discipline may not work. Investors would have to assume that market convergence would occur which is not possible to estimate.

Arbitrage Option Transaction Cost Holding Cost Interest Inc. Convergence
Buy// Sell $853,000 None $300,000 $4 m -$.85m =$3.5
Buy/Short $1,220,000 $600,000 $300,000 $4m-1.22m=$2.78m
Swap None $2,000,000 None $4m

Based on this analysis I would propose that the Swap option is the best. It appears that there is a profit to be made regardless of the option chosen.

On the basis of this analysis I would propose that there may be other factors that would explain this phenomenon. Other factors that may come into play are international relations, currency exchange rates and the length of time that an investor may be willing to wait for his/her profits. Market discipline may not be present based on this fact. One would also have to take into account the holding costs and the interest income in addition to the transaction costs. The longer the investor is willing to hold the stock the more the spread. I understand the spread to be the cost paid to the investor for holding the stock rather than having the funds to invest in the market. This would give you an immediate convergence which may or may not be accurate. All the arbitrage options involve some degree of risk which may be unattractive to a potential investor.

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