Econ 138: Financial and Behavioral Economics

Dual-Listed Companies: Case Studies in Arbitrage Risk

February 15, 2017

Reading:
A. De Jong et al., The Risk and Return of Arbitrage in Dual-Listed
Companies, Course Reader.
N. Barberis and R. Thaler, “A Survey of Behavioral Finance,”
Section 2.3, Course Reader.

Lecture 9 – DLC Arbitrage: R. J. Hawkins Econ 138: Financial and Behavioral Economics 1/ 32
Dual-Listed Companies and Arbitrage Risk

Agenda:
1 Overview.
2 What is a dual-listed company (DLC)?
3 How do DLCs behave in the capital markets?
4 Arbitrage risk and the limits of arbitrage.
5 Sources of observed capital-market behavior.
6 Pulling it all together.

Lecture 9 – DLC Arbitrage: R. J. Hawkins Econ 138: Financial and Behavioral Economics 2/ 32
Dual-Listed Companies and Arbitrage Risk

Overview:
Arbitrage is a key concept in financial economics.

Limited arbitrage is a key concept in behavioral financial

economics.

Dual-listed companies (DLCs) provide a natural experiment

for financial economics.
DLCs are also known as:
1 Siamese twins.
2 Twin securities.

Lecture 9 – DLC Arbitrage: R. J. Hawkins Econ 138: Financial and Behavioral Economics 3/ 32
Dual-Listed Companies and Arbitrage Risk

Overview
DLCs differ from cross-listed stocks.

Cross-listing is when a firm lists shares on one or more foreign

stock exchanges in addition to the firm’s domestic exchange.

Different exchanges often involve different currencies.

Examples include:
Company Ticker (Exchange)
Blackberry Ltd. BB.TO (Toronto), BBRY.BA (Buenos Aires)
Enbridge ENB (NYSE), ENB.TP(TSX)
Ericsson ERIC (NASDAQ), ERICN.MX (Mexico)
Nokia NOK (NYSE), NOKI.HE (Helsinki), NOKIA.PA (Paris)
Sony SNE (NYSE), SON1.F (Frankfurt), SON1.SG (Stuttgart)
Statoil ASA STO (NYSE), STLFUT.OL (Oslo)
Toyota TM (NYSE), TYT.L (London), TMN.MX (Mexico)

Lecture 9 – DLC Arbitrage: R. J. Hawkins Econ 138: Financial and Behavioral Economics 4/ 32
Dual-Listed Companies and Arbitrage Risk

Overview:
A DLC structure involves two companies:

incorporated in different countries.

agreeing to operate as a single enterprise.

that retain a separate legal identity and stock-exchange

listing.

where shares represent claims on exactly the same underlying

cash flows.

In an integrated and efficient market stock prices of the twin pair

should move in lockstep.

Lecture 9 – DLC Arbitrage: R. J. Hawkins Econ 138: Financial and Behavioral Economics 5/ 32
Dual-Listed Companies and Arbitrage Risk

Overview:
How do DLCs behave in the capital markets?

Significant mispricing is seen.

Mispricing persists for extended periods.

Mispricing exists despite being nearly perfect substitutes.

Mispricing presents profit opportunity: nearly 10% per year.

Mispricing seen as a result of limited arbitrage:

Idiosyncratic risk associated with capital and horizon

constraints limit arbitrage.

Lecture 9 – DLC Arbitrage: R. J. Hawkins Econ 138: Financial and Behavioral Economics 6/ 32
Dual-Listed Companies and Arbitrage Risk

Overview:
Sources of risk include:
Lack of convertibility.
Shares retain a separate identity.
Arbitrage positions are convergence trades.

Convergence trades have horizon risk.

Must hold until convergence achieved.
Holding periods can be years.

Convergence trades have idiosyncratic risk.

Volatility can exceed 30%.
Daily 1% Value-at-Risk is around -4%.

Lecture 9 – DLC Arbitrage: R. J. Hawkins Econ 138: Financial and Behavioral Economics 7/ 32
Dual-Listed Companies and Arbitrage Risk

What is a Dual-Listed Company?

Dual-Listed Companies:

are the result of a merger between two firms

are incorporated in different countries.

agree to combine their activities and cash flows.

keep separate shareholder registries and identities.

distribute the cash flows to their shareholders using a ratio

laid out in the equalization agreement.

Lecture 9 – DLC Arbitrage: R. J. Hawkins Econ 138: Financial and Behavioral Economics 8/ 32
Dual-Listed Companies and Arbitrage Risk

What is a Dual-Listed Company?

The three (3) ways to structure a DLC are:

1 Combined Entities Structure:
Key characteristic: holding company structure.
Holding company pays dividends according to predefined ratio.
The two companies each have their own shareholder base,
domiciles, and listings.

Lecture 9 – DLC Arbitrage: R. J. Hawkins Econ 138: Financial and Behavioral Economics 9/ 32
Dual-Listed Companies and Arbitrage Risk

What is a Dual-Listed Company?

The three (3) ways to structure a DLC are:

2 Separate Entities Structure:
No holding company structure: operating activities remain
fully owned by each of the two merged companies.
A contractual agreement between the twins provides for
equalized payments to shareholders.
The two companies each have their own shareholder base,
domiciles, and listings.

Lecture 9 – DLC Arbitrage: R. J. Hawkins Econ 138: Financial and Behavioral Economics 10/ 32
Dual-Listed Companies and Arbitrage Risk

What is a Dual-Listed Company?

The three (3) ways to structure a DLC are:

3 Stapled-Stock Structure:
No holding company structure.
Shares in each firm are “stapled” to each other and
distributed.
The two companies each have their own shareholder base,
domiciles, and listings.

Lecture 9 – DLC Arbitrage: R. J. Hawkins Econ 138: Financial and Behavioral Economics 11/ 32
Dual-Listed Companies and Arbitrage Risk

What is a Dual-Listed Company?

DLC Countries Type

Royal Dutch / Shell NL/UK Combined
Unilever NL / Unilever PLC NL/UK Separate
ABB CH/SE Combined
Smithkline Beecham UK/US Stapled
Fortis / Shell NE/BE Combined
Elsevier/Reed International NE/UK Combined
Rio Tinto AU/UK Separate
Dexia FR/BE Combined
Merita / Nordbanken FI/SE Combined
Zürich Allied/Allied Zürich CH/UK Combined
BHP Billiton AU/UK Separate
Brambles Industries AU/UK Separate

Lecture 9 – DLC Arbitrage: R. J. Hawkins Econ 138: Financial and Behavioral Economics 12/ 32
Dual-Listed Companies and Arbitrage Risk
How do DLCs behave in the capital markets?

Royal Dutch / Shell

40

30
DEVIATION FROM PARITY (%)

20

10

-10

-20

-30

-40
80 85 90 95 00 05
TIME (year)

Lecture 9 – DLC Arbitrage: R. J. Hawkins Econ 138: Financial and Behavioral Economics 13/ 32
Dual-Listed Companies and Arbitrage Risk
How do DLCs behave in the capital markets?

Unilever NL / Unilever PLC

40

30
DEVIATION FROM PARITY (%)

20

10

-10

-20

-30

-40
80 85 90 95 00 05
TIME (year)

Lecture 9 – DLC Arbitrage: R. J. Hawkins Econ 138: Financial and Behavioral Economics 14/ 32
Dual-Listed Companies and Arbitrage Risk
How do DLCs behave in the capital markets?

ABB AG / ABB AG
30
DEVIATION FROM PARITY (%)

20

10

-10

-20

-30
90 92 94 96 98 00
TIME (year)

Lecture 9 – DLC Arbitrage: R. J. Hawkins Econ 138: Financial and Behavioral Economics 15/ 32
Dual-Listed Companies and Arbitrage Risk
How do DLCs behave in the capital markets?

Smithkline Beecham H Shares / Smithkline Beecham E Shares

20
DEVIATION FROM PARITY (%)

10

-10

-20
88 90 92 94 96 98
TIME (year)

Lecture 9 – DLC Arbitrage: R. J. Hawkins Econ 138: Financial and Behavioral Economics 16/ 32
Dual-Listed Companies and Arbitrage Risk
How do DLCs behave in the capital markets?

Fortis NV / Fortis AG
20
DEVIATION FROM PARITY (%)

10

-10

-20
90 92 94 96 98 00 02
TIME (year)

Lecture 9 – DLC Arbitrage: R. J. Hawkins Econ 138: Financial and Behavioral Economics 17/ 32
Dual-Listed Companies and Arbitrage Risk
How do DLCs behave in the capital markets?

Rio Tinto Ltd. / Rio Tinto PLC

20
DEVIATION FROM PARITY (%)

10

-10

-20
95 96 97 98 99 00 01 02 03
TIME (year)

Lecture 9 – DLC Arbitrage: R. J. Hawkins Econ 138: Financial and Behavioral Economics 18/ 32
Dual-Listed Companies and Arbitrage Risk
How do DLCs behave in the capital markets?

Dexia France / Dexia Belgium

20
DEVIATION FROM PARITY (%)

10

-10

-20
96 97 98 99 00
TIME (year)

Lecture 9 – DLC Arbitrage: R. J. Hawkins Econ 138: Financial and Behavioral Economics 19/ 32
Dual-Listed Companies and Arbitrage Risk
How do DLCs behave in the capital markets?

Merita Ltd. / Nordbanken Holding AB

20
DEVIATION FROM PARITY (%)

10

-10

-20
97 98 99
TIME (year)

Lecture 9 – DLC Arbitrage: R. J. Hawkins Econ 138: Financial and Behavioral Economics 20/ 32
Dual-Listed Companies and Arbitrage Risk
How do DLCs behave in the capital markets?

Zürich Allied / Allied Zürich

25
20
DEVIATION FROM PARITY (%)

15
10
5
0
-5
-10
-15
-20
-25
10/98 01/99 04/99 07/99 10/99 01/00
TIME (year)

Lecture 9 – DLC Arbitrage: R. J. Hawkins Econ 138: Financial and Behavioral Economics 21/ 32
Dual-Listed Companies and Arbitrage Risk
How do DLCs behave in the capital markets?

BHP Billiton Ltd. / BHP Billiton PLC

20

10

-10

-20
01 02 03

Lecture 9 – DLC Arbitrage: R. J. Hawkins Econ 138: Financial and Behavioral Economics 22/ 32
Dual-Listed Companies and Arbitrage Risk
How do DLCs behave in the capital markets?

Brambles Ltd. / Brambles PLC

30
DEVIATION FROM PARITY (%)

20

10

-10

-20

-30
01 02 03
TIME (year)

Lecture 9 – DLC Arbitrage: R. J. Hawkins Econ 138: Financial and Behavioral Economics 23/ 32
Dual-Listed Companies and Arbitrage Risk
How do DLCs behave in the capital markets?

Arbitrage in Practice

Arbitrage: basic blocking & tackling includes:

Margin and margin calls: Regulation T?

Threshold levels: buy & sell.

Commission costs.

Daily mark-to-market.

Investor withdrawal.

Lecture 9 – DLC Arbitrage: R. J. Hawkins Econ 138: Financial and Behavioral Economics 24/ 32
Dual-Listed Companies and Arbitrage Risk
How do DLCs behave in the capital markets?

Unilever NL / Unilever PLC

40
Rational
30
DEVIATION FROM PARITY (%)

arbitrageurs are
20
concerned about
10
possible adverse
0 price movements in
-10 the short run, even
-20 when they know
-30 that prices will
-40
converge eventually.
80 81 82 83
TIME (year)

Lecture 9 – DLC Arbitrage: R. J. Hawkins Econ 138: Financial and Behavioral Economics 25/ 32
Dual-Listed Companies and Arbitrage Risk
How do DLCs behave in the capital markets?

Arbitrage in Practice

Volatility:

Both the total and the idiosyncratic volatility of arbitrage

returns are much larger than the annualized volatility of the
S&P 500.

The volatility of DLC arbitrage consistently exceeds the risk of

investing in the S&P 500 by almost 50%.

This is especially striking in light of the fact that the arbitrage

strategies involve hedged long-short positions.

Lecture 9 – DLC Arbitrage: R. J. Hawkins Econ 138: Financial and Behavioral Economics 26/ 32
Dual-Listed Companies and Arbitrage Risk
How do DLCs behave in the capital markets?

Arbitrage in Practice

Risk Summary:

Negligible fundamental risk and low systematic risk.

High idiosyncratic risk (including a high frequency of extreme

returns).

Uncertainty about the horizon at which convergence takes

place.

This evidence is consistent with idiosyncratic risk deterring

arbitrage activity and impeding efficient pricing.

Lecture 9 – DLC Arbitrage: R. J. Hawkins Econ 138: Financial and Behavioral Economics 27/ 32
Dual-Listed Companies and Arbitrage Risk
How do DLCs behave in the capital markets?

Arbitrage in Practice

Potential Risk Sources:

Legal Risk.

Tax Risk.

Availability of stock to short.

These sources of risk are unlikely in these DLCs.

Lecture 9 – DLC Arbitrage: R. J. Hawkins Econ 138: Financial and Behavioral Economics 28/ 32
Dual-Listed Companies and Arbitrage Risk
How do DLCs behave in the capital markets?

DLC Unification
Why?

Premiums or discounts seen as undesirable.

Greater liquidity.

Elimination of investor confusion caused by the complicated

structure.

Lecture 9 – DLC Arbitrage: R. J. Hawkins Econ 138: Financial and Behavioral Economics 29/ 32
Dual-Listed Companies and Arbitrage Risk
How do DLCs behave in the capital markets?

DLC Unification
How?

Stock swap.

Create a new entity.

Lecture 9 – DLC Arbitrage: R. J. Hawkins Econ 138: Financial and Behavioral Economics 30/ 32
Dual-Listed Companies and Arbitrage Risk
How do DLCs behave in the capital markets?

Dexia France / Dexia Belgium

20
DEVIATION FROM PARITY (%)

Unification
10
announcements
eliminate horizon
0 uncertainty and
mispricing vanishes
-10 almost
instantaneously.
-20
99 00
TIME (year)

Lecture 9 – DLC Arbitrage: R. J. Hawkins Econ 138: Financial and Behavioral Economics 31/ 32
Dual-Listed Companies and Arbitrage Risk
How do DLCs behave in the capital markets?

In summary:

Large deviations from parity are seen.

Deviations exist even when fundamental risk, transaction

costs and short-sale constraints are not an issue.

DLC arbitrage involves considerable uncertainty.

There is prolonged mispricing of large, well-traded

international equity securities.

Arbitrage is not successful in eliminating this mispricing.

This evidence supports theories that emphasize the importance

of idiosyncratic risk as an impediment to arbitrage.

Lecture 9 – DLC Arbitrage: R. J. Hawkins Econ 138: Financial and Behavioral Economics 32/ 32