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In early January 1996. Ms. Joanne Partridge. Director of Research at High Street Global Advisors ( “High Street” ) . a Boston-based planetary investing direction organisation. was analyzing the monetary value behaviour of the portions of Royal Dutch Petroleum and Shell Transport and Trading. It seemed that Royal Dutch and Shell should merchandise in fixed proportions since they represented tantamount categories of portions of the same keeping company. However. the ratio of portion monetary values had been anything but changeless. For illustration. Shell traded at a premium to Royal Dutch during 1990 and 1991. while Royal Dutch traded at a premium to Shell subsequent to 1991. Soon. the premium of Royal Dutch over Shell was at an all-time high of about 12 % .

Joanne Partridge was seeking to understand the chances presented by the Royal Dutch/Shell pricing disagreement. Several of High Street’s U. S. domestic equity and planetary equity portfolios presently held important places in Royal Dutch. These places could potentially be sold and replaced with equivalent-sized places in Shell. In add-on. the house had late landed several new histories. and would shortly be puting the financess. It would hold to make up one’s mind whether these new histories should have Royal Dutch or Shell. Finally. High Street managed a hedge fund. High Street Partners. which could try to arbitrage the monetary value disagreement by taking a long place in Shell and an countervailing short place in Royal Dutch.

High Street Global Advisors

High Street Global Advisors managed about $ 40 billion of tax-free assets for pension financess. foundations and gifts. and about $ 15 billion in common financess held by single investors. Most of these assets were in equity portfolios. whose investing authorizations ranged from strictly U. S. domestic to non-U. S. to to the full planetary.

High Street viewed the universe as dwelling of one planetary economic system. Consequently. it emphasized measuring investing chances in a planetary context. At the nucleus of the firm’s equity investing capableness was a squad of analysts who followed planetary industries such as chemicals. pharmaceuticals. cars. and oil. and who recommended their best stock choices within these industries to the

________________________________________________________________________________________________________________ Professors Kenneth A. Froot and Andre F. Perold prepared this instance. HBS instances are developed entirely as the footing for category treatment. Cases are non intended to function as indorsements. beginnings of primary informations. or illustrations of effectual or uneffective direction. Much of the informations in the instance is drawn from Kenneth A. Froot and Emil Dabora. “How are Stock Prices Affected by the Location of Trade? . ” Harvard University. May 1996.

Copyright © 1996 President and Fellows of Harvard College. To order transcripts or bespeak permission to reproduce stuffs. name 1-800-545-7685. write Harvard Business School Publishing. Boston. MA 02163. or travel to http: //www. hbsp. Harvard University. edu. No portion of this publication may be reproduced. stored in a retrieval system. used in a spreadsheet. or transmitted in any signifier or by any means—electronic. mechanical. run offing. entering. or otherwise—without the permission of Harvard Business School.

This papers is authorized for usage merely in Speculation. Crisis & A ; Behavioral Finance ( Huberman ) EMBA FA14 by Gur Huberman at Columbia Business School from July 2014 to January 2015. assorted equity portfolio directors. Partridge played a cardinal function in giving way to these analysts and in pull offing the flow of thoughts between them and the portfolio directors. Portfolio direction at High Street was by and large governed by a value-investing doctrine harmonizing to which securities were purchased if their monetary values were attractive comparative to underlying company basicss. In the instance of Royal Dutch. the oil analyst was urging the company on the footing of its lower price-to-book and price-earnings ratios than the major U. S. oil houses and because the company was contemplating certain refinery closures and other runing restructurings that would better its fight.

Royal Dutch Petroleum and Shell Transport and Trading

Royal Dutch Petroleum and Shell Transport and Trading were non independent companies. The two were linked to one another by corporate charter. which mandated that hard currency flows to the equity holders of each company should be distributed in a 60/40 ratio. ( See Exhibit 1 for balance sheets and income statements of the combined Group companies. ) The companies stated that. “the RoyalDutch/Shell Group of companies has grown out of a 1907 confederation between Royal Dutch and Shell Transport by which the two companies agreed to unify their involvements on a 60/40 footing while staying separate and distinguishable entities. ”

The organisational construction of the Group companies is depicted in Exhibit 2. All subordinate companies’ portions were held by the Group Holding Companies. which in bend were owned by the two parent companies. Royal Dutch Petroleum and Shell Transport & A ; Trading. in the ratio of 60/40. Royal Dutch and Shell were independently incorporated in the Netherlands and England. severally. The companies’ confederation meant that all influxs from and escapes to stockholders were disconnected 60/40. 1 Uniting this 60/40 split with the figure of portions of Royal Dutch and Shell outstanding. meant that one portion of Royal Dutch was entitled to the same hard currency flows as 9. 2744 portions of Shell. 2

The Group had attempted to do information widely available refering parent company linkages. In add-on to being explained at the beginning of each Annual Report. the corporate connexions were detailed in 20F entries to the U. S. SEC. The linkages were besides the topic of a dedicated analyst/investor usher. While the Group actively attempted to divide the cashflows harmonizing to the 60/40 ratio. there were a figure of factors that caused dividend payments to divert away from that ratio. These issues are discussed in the Appendix below. Analysts at High Street believed these factors to be comparatively minor.

Royal Dutch and Shell were listed on nine exchanges in Europe and the United States. Most of Royal Dutch’s trading activity took topographic point in the United States and the Netherlands markets. whereas Shell’s trading occurred preponderantly in the U. K. market. In New York. nevertheless. Shell portions did trade as American Depository Receipts ( ADRs ) . with one ADR being tantamount to six portions of Shell Transport and Trading. Thus. 1. 5457 ( 9. 2744/6 ) Shell ADRs were tantamount to one portion of Royal Dutch. Geographical ownership information for Royal Dutch and Shell are shown in Exhibit 3. Exhibit 4 contains information on the trading volume of Royal Dutch and Shell in New York. 1?Royal Dutch and Shell Transport shall portion in the aggregative net assets and in the net sum dividends and involvement received from Group companies in the proportion of 60/40.

It is further arranged that the load of all revenue enhancements in the nature of or matching to an income revenue enhancement leveeable in regard of such dividends and involvement shall fall in the same proportion. ” Royal Dutch 20-F. 1993. pp. 1-2. Specifically. the company distributed corporate revenue enhancement shields ( generated by Shell’s dividends under UK revenue enhancement jurisprudence ) on a 60/40 footing to the stockholders of both companies ( see the Appendix below ) . 2As of January 1996. there were 536. 074. 088 portions of Royal Dutch and 3. 314. 503. 242 portions of Shell outstanding. London. and Amsterdam since 1991. Royal Dutch had long been included in the S & A ; P 500 and the most popular Amsterdam stock index. the CBS Herbeleggings. Similarly. Shell had long been included in the major index of U. K. stocks. the Financial Times Allshare Index ( FTSE ) . 3 Although Royal Dutch was a foreign-owned corporation. it was considered a U. S. stock by many institutional investors by virtuousness of its inclusion in common U. S. stock indexes. Major institutional retentions of Royal Dutch and Shell are listed in Exhibits 5 and 6.

It appeared that arbitrage across markets disciplined the monetary value of Royal Dutch. so that it was basically equal around the universe. That is. at a given clip. it would be an tantamount sum to purchase a portion of Royal Dutch in Amsterdam as it would in New York. The same was true of Shell monetary values in London and New York. although for Shell the geographic disparities were by and large slightly larger. ( See Exhibit 7 for historical geographic monetary value disparities of Royal Dutch and Shell and Exhibit 8 for current pricing differentials. ) However. the monetary value of Royal Dutch fluctuated well when compared with the monetary value of Shell. For illustration. on January 3. 1996. portions of Royal Dutch and Shell closed in Europe at fl227. 8004 ( Amsterdam ) and? 8. 6300 ( London ) . severally. At prevalent exchange rates. these monetary values were close to those that prevailed on the same twenty-four hours at the stopping point of the New York markets. 5 ( See Exhibit 9. )

However. in both Europe and the United States. Royal Dutch was well more expensive than Shell ( see Exhibits 8 and 9 ) . Partridge was funny about the nature of the pricing derived function. She wondered whether the strong public presentation of the S & A ; P 500 compared to international stocks in 1995 might explicate portion of the current premium on Royal Dutch portions. 6 In peculiar. Partridge wondered whether Royal Dutch would look more extremely correlated with the United States and Netherlands markets than Shell. and. likewise. whether Shell would look more extremely correlated with the U. K. market than Royal Dutch. If so. so an addition in. state. U. S. stocks would. all else equal. consequence in an addition in the monetary value of Royal Dutch relation to that of Shell.

To look into this. Partridge had an analyst compare the betas of Royal Dutch and Shell. The analyst regressed the difference between the returns on Royal Dutch and Shell on both market index and currency returns. ( The betas of the Royal Dutch / Shell return derived function are reported in Exhibit 10. ) For illustration. a beta of 0. 2 against the S & A ; P 500 would bespeak that a 1 % addition in U. S. stocks ( keeping other countries’ stock monetary values and currencies constant ) would be associated with a 20 footing point addition in the monetary value of Royal Dutch relation to that of Shell. Partridge besides knew that dividend withholding revenue enhancements might change investor perceptual experiences of comparative stock value.

This should non hold been really of import for private investors in the United Kingdom. Netherlands. and United States. all of whom faced symmetric withholding revenue enhancements on the dividends of Royal Dutch and Shell. However. pension financess sometimes faced revenue enhancement dissymmetries with regard to the two stocks. For illustration. U. K. pension financess were exempt from keep backing revenue enhancements on Shell. but non on Royal Dutch. and conversely. Netherlands pension financess were exempt from keep backing revenue enhancements on Royal Dutch. but non on Shell. Partridge wondered whether revenue enhancement issues could explicate the behaviour of the comparative monetary value of Royal Dutch versus Shell. Exhibit 11 shows the dividend and withholding revenue enhancements faced by different investor groups.

Analysis of the Investment Opportunities

Before proposing any trades based on the monetary value derived function between Royal Dutch and Shell. Partridge wanted to better understand the costs that might be involved. To make so. she enlisted the aid of High Street’s trading desk and besides a outstanding Wall Street house through which High Street funneled much of its volume in international stocks. and which High Street besides used for customized derived functions minutess.

Partridge began by believing through the economic sciences of selling Royal Dutch and buying Shell. This would be relevant for the portfolios in which Royal Dutch was soon being held. and which had a authorization for having “foreign” every bit good as “domestic” portions. Some of High Street’s clients had given it rigorous “U. S. -only” mandates which permitted it to keep Royal Dutch but non Shell. On the New York Stock Exchange. both Royal Dutch and Shell ADRs were typically quoted at a 25? bid-offer spread in small-sized measures ( one 1000 to five thousand portions ) . The spread normally would be wider for big sized trades. In add-on. for trades in listed stocks. High Street paid its agents a one-way committee of 5? per portion. In Amsterdam. Royal Dutch was typically quoted at a spread of fl0. 3 for little trades. and. in London. Shell was typically quoted at a spread of? 0. 03 for little trades. In both Amsterdam and in London. High Street would pay one-way committees on top of these spreads of 30 footing points.

The United Kingdom besides imposed Stamp Tax. a 50 footing point transportation revenue enhancement on purchases of U. K. stocks. including Shell. 7 Trades in Royal Dutch in Amsterdam and in Shell in London would besides necessitate the transition from guldens and lbs to dollars. These currencies tended to merchandise at bid-ask spreads of six footing points. If High Street’s hedge fund were to try to arbitrage the monetary value disagreement. one option would imply selling short portions of Royal Dutch and buying portions of Shell. In a short sale. the hedge fund would borrow portions of Royal Dutch. sell the portions. and ulterior buy back them and return them to the loaner. The hedge fund would hold to reimburse the loaner for any dividends paid on Royal Dutch portions during this interim period. In add-on. the hedge fund would hold to pay a fee for borrowing the portions. This tended to run approximately 40 footing points per annum. This fee normally took the signifier of an involvement rate give-up on the returns of the short sale.

The returns of a short sale would normally be held as hard currency collateral to protect the loaner against borrower default. The hard currency would be invested in short-run instruments gaining LIBOR or somewhat less. and all but 40 footing points of this involvement income would be rebated to the hedge fund. The hedge fund besides would hold to finance its long place in Shell. Soon. it was able to borrow at a rate of LIBOR + 75 footing points ( on a to the full collateralized footing ) . The hedge fund frequently took significantly leveraged places. particularly in state of affairss where the hazard was deemed minimum. 8 There were other options available to the hedge fund affecting the usage of derived functions.

One set of schemes involved the usage of exchange-traded put and call options. There were reasonably active options markets for Royal Dutch in the United States and Shell in the United Kingdom. These were short-run options. nevertheless. with adulthoods of six months or less. The options were normally somewhat cheaper to merchandise than the implicit in portions. although with rollovers they would go more expensive. A potentially attractive characteristic of options-related schemes was that they permitted the hedge fund to easy orient its hazards in an asymmetric manner.

7 No Stamp Tax was levied on purchases of Shell ADRs. nevertheless. 8 On its hedge fund. High Street received a direction fee of 1 % per annum on net assets plus 20 % of net incomes earned in surplus of LIBOR.

A 2nd derivatives-related scheme involved the usage of a privately-negotiated entire return barter. The simplest entire return barters involved two counterparties holding to interchange the entire return on one instrument for the entire return on another. plus or minus a fee. where the entire return on an instrument is its monetary value grasp or loss during the keeping period. plus involvement or dividend income paid on the instrument during the keeping period.

Barters could be customized in about any manner. for illustration. to let the exchange of entire returns on differing implicit in sums ( “notional amounts” ) . or to include option-like characteristics. Swaps besides could be written for merely about any adulthood. The fee charged by the issuer of the barter typically depended on the easiness of trading in the implicit in instruments. the usage of options and other characteristics which might be embedded in the barter. and the credit-worthiness of the counterparty.

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