Dual-listed Companies - Arbitrage in DLCs

Arbitrage in DLCs

The mispricing in dual-listed companies has not gone unnoticed in the financial industry. There are a number of known cases of financial institutions that have tried to exploit the mispricing by setting up arbitrage positions in DLCs. These arbitrage strategies involve a long position in the relatively underpriced part of the DLC and a short position in the relatively overpriced part. For example, in the early 1980s an arbitrageur might have built up a long position in Royal Dutch NV and a short position in Shell Transport and Trading PLC. This position would have yielded profits when the relative prices of Royal Dutch and Shell converged to theoretical parity. An internal document of Merrill Lynch investigates arbitrage opportunities in six DLCs. Lowenstein (2000) describes arbitrage positions of Long-Term Capital Management (LTCM) in Royal Dutch/Shell. LTCM established an arbitrage position in this DLC in the summer of 1997, when Royal Dutch traded at an 8 to 10 percent premium. In total $2.3 billion was invested, half of which long in Shell and the other half short in Royal Dutch (Lowenstein, p. 99). In the autumn of 1998 large defaults on Russian debt created significant losses for the hedge fund and LTCM had to unwind several positions. Lowenstein reports that the premium of Royal Dutch had increased to about 22 percent and LTCM had to close the position and incur a loss. According to Lowenstein (p. 234), LTCM lost $286 million in equity pairs trading and more than half of this loss is accounted for by the Royal Dutch/Shell trade.

The example of LTCM is a good illustration of why arbitrage by financial institutions has not succeeded in eliminating the mispricing in DLCs. An important characteristic of DLC arbitrage is that the underlying shares are not convertible into each other. Hence, risky arbitrage positions must be kept open until prices converge. Since there is no identifiable date at which DLC prices will converge, arbitrageurs with limited horizons who are unable to close the price gap on their own face considerable uncertainty. De Jong, Rosenthal, and van Dijk (2008) simulate arbitrage strategies in 12 DLCs over the period 1980-2002. They show that in some cases, arbitrageurs would have to wait for almost nine years before prices have converged and the position can be closed. In the short run, the mispricing might deepen. In these situations, arbitrageurs receive margin calls, after which they would most likely be forced to liquidate part of the position at a highly unfavorable moment and suffer a loss. As a result, arbitrage strategies in DLCs are very risky, which is likely to impede arbitrage.