The theory of efficient markets says that the prices of financial assets fully reflect all public information. This includes dual-listed companies (DLCs), which is when two different stocks represent the same business. Royal Dutch and Shell agreed to operate as one business, but maintain separate legal identities and stock listings. Royal Dutch shareholders received 60% of the cash flows and Shell shareholders received 40% of the cash flow. Royal Dutch will always be worth 20% more (or 1.5x more). The law of one price is the idea that identical assets should trade at the same value; however, this price ratio wouldn’t stick, and would vary by 35%. This means that when the price ratio is wrong, traders don’t always fix them. As a result, there is arbitrage, which is when someone buys a cheaper asset and sells a more expensive equivalent to profit from this price gap.
Arbitrage can be limited in this scenario because Royal Dutch (U.S. & Netherlands) and Shell (U.K.) are traded in different countries. Because of differences in currency exchange rates, there is risk that shorting or buying a stock will generate a different return compared to if the purchases/currencies were in the same country. Another limitation is the cost of short selling. There are borrowing costs and restrictions on wanting to short a stock that a trader deems as “overpriced” or “overvalued.” Additionally, investors may experience “home bias” which is when people of their own country would rather trade a stock that is actually less favorable than a stock from a different country. For example, Americans feel more comfortable trading Apple just like British like trading Shell.
To summarize, although Royal Dutch/Shell contains a 60/40 ratio, in reality, short-selling restrictions, currency exchange rates, and home bias play a role in changing the price ratio.
Written by Mikael La Ferla
Mikael La Ferla 