the limits of arbitrage: evidence from dual-listed companies van dijk.pdf · the limits of...
TRANSCRIPT
The Limits of Arbitrage: Evidence from Dual-Listed Companies
Abe de Jong Erasmus University Rotterdam
Leonard Rosenthal Bentley College
Mathijs A. van Dijk Erasmus University Rotterdam
May 2003 Correspondence Mathijs A. van Dijk Department of Financial Management (Room F4-21) Erasmus University Rotterdam PO Box 1738 3000 DR Rotterdam THE NETHERLANDS Phone: +31 10 408 2748 Fax : +31 10 408 9017
1
The Limits of Arbitrage: Evidence from Dual-Listed Companies
Abstract
We study the limits of arbitrage in international equity markets by examining a sample of
dual-listed companies (DLCs). DLCs are the result of a merger in which both companies
remain incorporated independently. DLCs have structured corporate agreements that allocate
current and future equity cash flows to the shareholders of the parent companies according to
a fixed ratio. This implies that in integrated and efficient financial markets, the stock prices of
the parent companies will move together perfectly. Therefore, DLCs offer a unique
opportunity to study market efficiency and the roles of noise traders and arbitrageurs in equity
markets. We examine all 13 known DLCs that currently exist or have existed. We show that
for all DLCs large deviations from the theoretical price ratio occur. The difference between
the relative price of a DLC and the theoretical ratio is often larger than 10 percent in absolute
value and occasionally reaches levels of 20 to 50 percent. Moreover, deviations from parity
vary considerably over time for all DLCs. We find that return differentials between the DLC
parent companies can to a large extent be attributed to co-movement with domestic stock
market indices, consistent with Froot and Dabora (1999). These findings are evidence of
inefficiencies in financial markets that seem to be driven by noise trading. Our findings have
important implications for the effectiveness of arbitrage in international financial markets.
Keywords
Market efficiency, arbitrage, anomalies, international finance
JEL subject codes
F30, G14, G15
2
1. Introduction
In recent years, there has been increased debate between those who believe that stock markets
in developed countries are efficient and those who believe that there are behavioral reasons
which interfere with rational pricing by investors.1 Shleifer and Vishny (1997) make a
convincing argument for the limits of arbitrage, and in particular risk arbitrage. As early as
1986, Black described the effects of noise on financial markets. Noise trading is defined as
trading on noise as if it were information. According to Black, noise traders make markets
possible. On the other hand, the noise that these traders put in stock prices is cumulative and
without a counter-force prices will drift away from their underlying value. However,
information traders are able to benefit from deviations caused by noise traders and in an
arbitraging process the prices will move back to the fundamental value. Black (1986, p. 533)
asserts that: �All estimates of value are noisy, so we can never know how far away price is
from value.�
Subsequent studies have modeled the effects of noise trader risk on arbitrage (see De
Long, Shleifer, Summers, and Waldmann, 1990 and Shleifer and Vishny, 1997). In these
models, arbitrageurs may be driven out of the market by the possibility of adverse price
movements in the short-run, even though it is known that prices will converge eventually.
Recent studies argue that other impediments to textbook arbitrage exist in financial markets.
First, two traded assets may be similar, but are hardly ever perfect substitutes in the real
world. Second, arbitrage requires capital. This results in opportunity costs as well as holding
costs. Moreover, dedicating capital to a specific arbitrage position may induce unhedgeable
fundamental risk. Third, transaction costs (such as bid-ask spreads, commissions, and market
impact) are incurred in the set-up of an arbitrage position.
This paper studies the limits of arbitrage in real-world equity markets by looking at
mispricing in a sample of dual-listed companies (also referred to as Siamese twins). A dual-
listed company (DLC) structure involves two companies contractually agreeing to operate
their businesses as if they were a unified enterprise, while retaining their separate legal
identity and existing stock exchange listings. Well-known examples of DLCs are the Anglo-
Dutch combinations Royal Dutch/Shell and Unilever NV/PLC. In integrated and efficient
financial markets, stock prices of the twin pair should move together perfectly. DLCs offer a
unique opportunity to analyze market efficiency and the roles of noise traders and
1 See e.g. Rubinstein (2001) and Thaler (1999).
3
arbitrageurs, because the stocks of the twin pair are close substitutes. According to Black
(1986), we cannot measure the underlying value of a traded asset. However, DLCs provide an
excellent vehicle for examining the behavior of two assets of which the fundamental value
should be exactly the same.
Previous studies by Rosenthal and Young (1990) and Froot and Dabora (1999) have
shown that significant mispricing in three DLCs has existed over a long period of time.
Rosenthal and Young assert that no satisfactory explanation can be found for the price
disparity of the Royal Dutch/Shell and Unilever twins. Froot and Dabora also investigate the
Anglo-American corporation Smithkline Beecham and show that the prices of twin stocks are
correlated with the stock indices of the markets on which each of the twins has its main
listing. They conclude that the location of the trade matters for the pricing of DLCs.
We examine all 13 DLCs that exist or have existed to our knowledge. The motivation
for our study is three-fold. First, since the two previous papers were written, 10 additional
DLCs have been established, without any research on their structure, pricing and other issues
related to it.2 There have been no academic research papers which have examined all 13, their
similarities and differences, and their pricing patterns. Recent DLCs may have learned from
the older twins and the mispricing may be reduced. Moreover, equity markets may have
operated more efficiently in the 1990s than in the 1980s. Our second motivation is that 6 of
the 13 twins studied in this paper have unified the DLC into a single structure. The transition
from DLC to regular stock allows us to measure the effects in the market and the persistence
of mispricing. Third, we expect that more DLCs will be established in the future.
Understanding the pricing behavior is therefore not only important from the perspective of
arbitrage in equity markets, but also from a corporate finance viewpoint (e.g. the optimal legal
structure in cross-border mergers and problems in cost of capital estimation for twins with
unequal returns).
The issues involved in DLCs bear some resemblance to the closed-end fund puzzle.
Closed-end funds are traded mutual funds that hold a portfolio of other publicly traded funds.
The puzzling anomaly is that closed-end funds typically exhibit discounts of 10 to 20 percent
relative to their net asset value. Explanations offered in the literature stem from agency costs,
tax liabilities, asset illiquidity, and investor sentiment (see Lee, Shleifer, and Thaler, 1991).
2 Recently, the DLC structure was selected in the merger between U.S. cruise company Carnival Corporation and U.K. firm P&O Princess (Financial Times, October 27, 2002). In merger negotiations of Abbey National (U.K.) with National Australian Bank and Bank of Ireland with Alliance & Leicester (U.K.) the DLC structure was proposed, but both merger plans were abandoned (Financial Times, May 25, 1999 and July 8, 2002).
4
Brauer (1984) and Brickley and Schallheim (1985) show that the ending of a closed-end fund
leads to an immediate disappearance of the discount. Pontiff (1996) provides evidence that
there is a relation between the discounts of closed-end funds and the costs of arbitrage.
Although studying closed-end funds yields several interesting insights in the mechanics of
arbitrage in equity markets, an analysis of DLCs is a much more straightforward way to
investigate this issue. In the case of closed-end funds, the price of the fund is compared with
the net asset value. A major problem in this literature is the determination of the asset value
which is hampered by e.g. agency costs, taxation, and liquidity. In contrast, the security prices
of DLCs are derived from one and the same underlying value. Therefore, we do not need to
construct and apply a subjective estimate of value.
Our results show that for each of the 13 DLCs large deviations from the theoretical
price are present. The maximum absolute deviations range from 15 percent to almost 50
percent. We also find that the deviations are time-varying. To a large extent, the variations can
be explained by co-movement with domestic stock market indices. These findings are
evidence of inefficiencies in financial markets that may well be driven by noise trading.
Moreover, the limitations of arbitrage are clearly illustrated by the obvious mispricing of
DLCs.
Our results imply that noise trader risk may lead to significant deviations of the prices
of two assets that are close perfect substitutes. First, this evidence suggests that sizeable
mispricing may well exist for common stocks. While investors in DLCs have the price of the
other twin as a point of reference, investors in regular stocks lack such guidance. As a result,
mispricing of regular stocks could be even more pronounced than mispricing in DLCs.
Second, the results are evidence of inefficient markets in which adverse effects of noise
trading are not eliminated by arbitrage. Welch (2000) surveyed 226 academic financial
economists and reported that 79 percent of the finance professors agreed with the statement
that, by and large, public securities markets are efficient. A second statement, that financial
markets offer no arbitrage opportunities, is agreed upon by 75 percent of the economists. Our
paper shows that reasonable doubt can be casted on the first statement. While the second
statement about arbitraging is more in line with our results, we argue that limitations to
arbitrage are a more likely reason than the absence of inefficiencies.
The remainder of the paper is structured as follows. In section 2 we describe the
structure of dual-listed companies. Section 3 provides the data description. We examine the
magnitude of the deviations of the twin prices from theoretical parity in section 4. Our testing
methodology and the empirical results are presented in section 5. Section 6 concludes.
5
2. The structure of dual-listed companies
Dual-listed companies are the result of a merger between two firms in which the firms agree
to combine their activities and cash flows, but the corporations keep separate shareholder
registries and identities. In this section, we briefly explain the structure of a DLC based on an
example from our data set, Reed Elsevier. Subsequently, we discuss structures as well as
motives for a DLC structure and introduce the 13 DLCs in our data set.
On January 1, 1993, Elsevier NV (Elsevier) and Reed International PLC (Reed)
merged their businesses. (See Reed Elsevier Form 20-F for 1998). Under the merger, almost
all of the operating activities of both firms were put into Reed Elsevier PLC, a U.K.
corporation. Most of the treasury and related finance functions were put into Elsevier Reed
Finance B.V., which is incorporated in the Netherlands. The operations of the businesses have
been managed on unified basis, but both Reed and Elsevier retain their separate identities.
Their shares trade on the London, Amsterdam, and New York Stock Exchange. Reed and
Elsevier each holds a 50 percent interest in Reed Elsevier PLC. Reed International holds a 46
percent interest in Elsevier Reed Finance BV, while Elsevier holds the remaining 54 percent.
In addition, Reed holds a 5.8 percent indirect interest in Elsevier, which reflects the higher
market capitalization of Reed compared with Elsevier just prior to the merger. Elsevier also
owns shares in certain of the Dutch subsidiaries of Reed Elsevier PLC, which enables Elsevier
to receive dividends within its own tax jurisdiction. The effect is to mitigate potential tax costs
for Reed Elsevier. With respect to the latter, the companies have indicated the combination
was expected to cut the combined companies� effective tax rate by up to one percentage point
per year.3 The deal was structured so that there was no exchange of cash and therefore no
capital gains tax. Taking all of this into account, Reed International shareholders have a 52.9
percent economic interest in the net income of Reed Elsevier combined, and Elsevier
shareholders have a 47.1 percent economic interest. In the case of Reed and Elsevier, the
boards of director of both Elsevier and Reed each manage their shareholdings in Reed
Elsevier and Reed Finance BV. Elsevier and Reed are each entitled to appoint ten directors
and decisions of the board of directors of Reed Elsevier requires a two-thirds majority. As part
of the merger, Reed and Elsevier set up an equalization agreement to insure that the ordinary
shareholders of both firms have equivalent dividend and capital rights in the net income and
3 See Financial Times, February 18, 1993. Two partners at Price Waterhouse who worked on the deal pointed out to us that this arrangement allows Reed Elsevier to earn interest on its funds without taxes by legally investing it in a tax haven.
6
net assets of the combined businesses. Given the significant effect of differences in taxation of
dividends in the U.K. and the Netherlands, Reed�s direct and indirect interest of 52.9 percent
in Reed International, Elsevier�s 54 percent interest in Elsevier Reed Finance, dividends and
capital rights are set such that one Elsevier ordinary share provides the economic equivalent
of 1.538 Reed ordinary shares in May 1997.4 The primary market for Reed shares is the
London Stock Exchange (LSE). Shares also trade the New York Stock Exchange (NYSE) as
ADRs, where each ADR equals four Reed ordinary shares. In addition, Reed shares trade in
Amsterdam (ASX). Elsevier ordinary shares trade primarily on the Amsterdam Stock
Exchange. They also trade on the NYSE as ADRs where each ADR equals two ordinary
shares. Elsevier shares trade as well on the London Stock Exchange.
DLCs can be structured in three alternative ways. The DLC structure of Elsevier/Reed
International is a combined entities structure.5 The key characteristic is that the assets of the
two companies are held by one or more jointly-owned holding companies. The latter pays
dividends to the two companies, which then distributes them to the shareholders using a
predetermined ratio as outlined in an equalization agreement. The two companies each have
their own shareholder base, domiciles and listings. Alternatively, in the separate entities
structure, the operating activities remain fully owned by each of the two merged companies.
The companies also retain their domiciles, listings and shareholders. The equalization
agreement is set up to insure that there is equal treatment of both companies� shareholders in
voting and economic terms. There are cross-holdings of special dividend access shares or
contractual payments to provide for equalization payments to shareholders. Finally, in the
stapled stock structure, shares in each firm are �stapled� to each other, so they cannot be
traded separately. The idea is to minimize the likelihood of the share of one company from
trading at a discount to the other.
Table 1 describes the types of structure used by each DLC as well as their date of
merger. The two eldest twins are the Anglo-Dutch combinations Royal Dutch/Shell and
Unilever. Extensive descriptions of these twins can be found in Rosenthal and Young (1990)
and Froot and Dabora (1999). In 1988, almost fifty years after the previous DLC, ABB, a
Swiss-Swedish engineering group was created. This DLC set the stage for a flow of DLCs,
4 See Reed Elsevier 20-F for 1998. There is an elaborate discussion of the differences in the tax treatment of dividends in the U.K. vs. the Netherlands, and how dividend decisions are made so as to take them into account with respect to making the distribution of cash flows economically equivalent. The so-called equalization ratio has changed over time to reflect stock splits for both companies. 5 See �Dual-Listed Company Transactions and Frustrating Action,� issued by the Panel on Takeovers and Mergers, April 26, 2002.
7
from Eurotunnel in 1989 to Brambles Industries in 2001. It is clear that the combined entities
structure predominates occurring in 7 (14 of the companies) of the 13 pairs (26 companies),
with the separate entities structure occurring 5 times and the stapled structure twice.
Interestingly, the country most often involved by far is the U.K. with 8 individual companies,
followed by the Netherlands with 4 and Australia, Sweden and Switzerland with 3 each. In the
newest transaction, whose completion is pending, one of the firms is also domiciled in the
U.K.. When the structure is broken down by country, the combined structure dominates for
Dutch, Swiss and Swedish firms, while the separate entity structure dominates in Australia.
What are the motivations for firms to adopt a DLC structure, instead of a regular
merger where a single share is created? The first motivation is taxation. A capital gains tax
could be owed if an outright merger took place, but no such tax consequence would arise with
a DLC deal. Differences in tax regimes may also favor the DLC, because cross-border
dividend payments are minimized. In addition, there may be favorable tax consequences for
the companies.6 A second motivation is the preservation of the (national) identity of each of
the twins. This is a political reason, because by maintaining separate firms, any problems with
an important local company being taken over by a foreign firm would be eliminated. The third
motive is the reduction of investor flow-back, which would depress the price of the stock of
one of the firms in their own market if the merger route were used instead. The thought
behind this is that some institutional investors cannot own the shares of firms domiciled
outside the home country or can only own such shares in limited quantity. In addition, in a
merger, the non-surviving firm would be removed from any indexes that exist. Index tracking
funds would then have to sell the shares of the surviving company. With the DLC structure,
all of this would be avoided.7 A fourth motive is that DLCs do not necessarily require
regulatory (anti-trust) consent and are not constrained by foreign investment approvals.8
Finally, the access to capital markets may be reduced when in a regular merger a quotation
disappears. Keeping a separate stock exchange listing which may allow each of the firms to
have better access to capital in their local market. This is based on the idea that local
investors are already familiar with the company (from the pre-DLC period). The DLC
structure also has disadvantages. The structure may hamper transparency for investors. In
6 See Reserve Bank of Australia Bulletin, October 2002, p. 7-13. 7 See Baker & McKenzie newsletter on DLCs of July 2001. 8 In the U.K., the DLC structure was brought within the City Code on Takeovers and Acquisitions in 2002. See �Dual-Listed Company Transactions and Frustrating Action,� issued by the U.K. Panel on Takeovers and Mergers, April 26, 2002.
8
addition, future capital market transactions (such as share repurchases and stock splits) are
more complex under the DLC structure.
3. Data
We collect daily stock prices, total returns in local currency, bid and ask prices, trading
volume, and the number of shares outstanding from Datastream. Bid and ask prices and
trading volume are generally not available in the first years of the sample. Datastream does
not supply bid-ask prices for Nordbanken AB and bid-ask prices and volume data for ABB
AB, the Swedish part of the ABB twin. For ABB AB, daily bid-ask prices and volume data
are obtained from Bloomberg. As no data on the Smithkline Beecham Equity Units (class E
shares) are available in Datastream, we use daily data from Bloomberg for the Smithkline
Beecham H and E shares.
We extract information about the theoretical price ratio of the twin prices from
corporate annual reports, the merger prospectus, and/or the unification prospectus. For seven
out of 13 twins, the theoretical price ratio is equal to 1:1. For the other six twins, we apply the
procedure outlined in Rosenthal and Young (1990) for the calculation of the theoretical price
ratio. This involves taking account of the number of shares outstanding for both parts of the
twin, as the current and future equity flows of these twin pairs are fixed at a specified ratio.
Daily exchange rates are obtained from Datastream. As domestic stock market indices
we use the ASX All Ordinaries index for Australia, the Brussels Allshare index for Belgium,
the SBF 250 index for France, the Helsinki HEX index for Finland, the CBS Allshare index
for the Netherlands, the Stockholmbörsen Allshare index for Sweden, the Swiss Performance
index for Switzerland, the FTSE Allshare index for the U.K., and the S&P 500 index for the
U.S. All indices are from Datastream, except for the FTSE and the S&P indices employed for
the Smithkline Beecham twin, which are taken from Bloomberg. Following Froot and Dabora
(1999), we measure the location of the trade effect using broad equity indices. Froot and
Dabora point out that the inclusion of several of the twins in the respective indices leads to a
bias in the estimated coefficients. They show that this bias is too small to affect the regression
results. As Royal Dutch forms a considerable part of the Dutch market index, however, we
remove Royal Dutch from the CBS Allshare index. The sample period for Royal Dutch/Shell
and Unilever is January 1, 1980 to October 3, 2002. The sample period for all other twins
starts at the date of the merger and ends either 20 trading days before the announcement date
of the share unification or at the last date in our full sample period. All returns are expressed
9
in log form. In line with Froot and Dabora, we leave all variables in local currencies and
include log returns on the relevant exchange rate on the right hand side of the regression when
explaining return differences.
4. Deviations from theoretical parity
Figure 1 depicts graphs of the log deviations of the relative price of all 13 twins from
theoretical parity. It is obvious from the graphs that log deviations from parity are often
staggeringly large. Moreover, they fluctuate considerably over time. These observations are
supported by the summary statistics of the price differentials for each twin as reflected in
Table 2. The mean absolute price differential ranges from 2.60 percent (Eurotunnel) to 11.94
percent (ABB), which is very large in economic terms. For all of the twins, the deviation from
theoretical parity exceeds 15 percent in absolute value at some point in time. For 5 out of 13
twins, absolute price gaps amounting to 20 percent or more occur, while 3 of the twins have
an absolute price differential of more than 35 percent at some point during the sample period.
An extreme example of price disparity is provided by ABB AG, which traded at a near 50
percent discount relative to the theoretical price ratio with ABB AB on January 13, 1988.
Log deviations from parity exhibit great variation over time for most twins. Mean
disparities are negative for 5 twins and positive for 8 twins. For all twins but BHP Billiton and
Zürich Allied/Allied Zürich, however, the deviation from theoretical parity assumes both
positive and negative values over the sample period. As can be observed from the graphs in
Figure 1, the disparity changes from negative to positive (or vice versa) frequently for many
twins. The substantial time-series variation in the price differential is reflected in the estimates
of the standard deviation depicted in the third column of Table 2, which range from 2.8
percent for Eurotunnel to 14.2 percent for ABB. There does not seem to be any indication that
the price gap is smaller (or larger) for twins that were established later in the sample period.
Price differentials are highly correlated for several twins, however. The correlation between
the log deviations from parity of Anglo-Dutch twins Royal Dutch/Shell and Unilever amounts
to 0.86, while the correlation between the Royal Dutch/Shell and Reed Elsevier price
differentials is equal to 0.71. Disparities of the Anglo-Australian twins Rio Tinto and BHP
Billiton show a correlation of 0.57, but neither moves together with the price gap of Brambles
Industries. The substantial correlations suggest that common factors may drive the price
differentials of dual-listed companies from specific countries. This supposition will be borne
out in section 5 of this paper.
10
Table 3 presents the test results of three different t-tests. The first column presents the
test statistic of a test of the null-hypothesis that the mean deviations from parity (in log-form)
are equal to zero for each individual twin. This hypothesis is strongly rejected for all 13 dual-
listed companies. Column 2 depicts test statistics of the null-hypothesis that mean daily
returns of the twin pairs are equal over the sample period when expressed in local currency.
The t-test fails to reject this hypothesis for all twins. Column 3 displays similar results for the
test for equality of mean returns when expressed in common currency. Table 4 investigates
whether the price differentials contain unit roots. We apply the augmented Dickey-Fuller tests
and include a trend and four lags of the first difference of the price differentials in the
regression. The results are mixed. For 6 out of 13 twins, we cannot reject the null-hypothesis
that price differentials contain a unit root at the 5 percent level. This signifies that the
hypothesis that the price ratio of these twins reverts toward theoretical parity in the long run is
not supported by the data. For the other 7 twins, the unit root hypothesis is rejected, indicating
that their price differentials at least exhibit some mean reversion. In the next section we
investigate whether relative movements in the stock market indices of the home countries of
the twin have an effect on the price differentials.
5. Empirical hypotheses and test results
This section examines whether the result of Froot and Dabora (1999) that the pricing of twin
stocks is affected by the location of the trade in the cases of Royal Dutch/Shell, Unilever, and
Smithkline Beecham can be confirmed in a sample that has been extended to include data on
all known dual-listed companies. We run the following regression for each twin9:
( ) tk
ktkj
jtji
ititBtAtBtA reIndexIndexrrrr εδγγβα ++++−+=− ∑∑∑−=
+−=
+=
+−−
1
1
0
1
1
01,1,,, ..21 , (1)
where A and B represent the twin pair, rA,t and rB,t are the log returns at time t of the first and
the second part of the twin in their local currencies, respectively (Table 1 defines what the
first and the second part is), Index1 and Index2 denote the log returns of the domestic market
indices corresponding to home country of twin A and twin B, and e.r. represents the log
9 Note that our specification differs from the basic Froot and Dabora (1999) regression framework in three ways. First, we do not include the S&P and the exchange rate of the U.S. dollar for all twins (except for Smithkline Beecham). Second, Froot and Dabora include a lead and a lag for all variables, while our set of leads and lags is based on the actual time differential. Third, we incorporate a lagged dependent variable in the regression, as the Durbin-Watson statistic indicates substantial autocorrelation in the error term. Neither of these methodological differences materially affects our results. The regression results of the basic Froot and Dabora regression are available from the authors on request.
11
changes in the exchange rate between the home currencies of twin A and twin B. As all twins
are defined in such a way that the country of twin B is in an earlier time zone than the country
of twin A, we include a lead of Index1 and a lag of Index2. Our null-hypothesis is that the
return difference of the twin should be uncorrelated with the right hand side variables. In
absence of non-synchronous measurement of currency returns and stock returns, we expect
the coefficient on the exchange rate to equal �1, and the coefficients of the lead and lag of the
exchange rate returns to be equal to 0. Under the alternative hypothesis, stock markets are
segmented and the return differential of a twin is positively affected by a shock in the Index1
and negatively affected by a shock in Index2.
Table 5 reports estimation results of equation (1) for all 13 twins in the sample. We
employ Newey-West standard errors in order to correct for heteroskedasticity and auto-
correlation. The reported coefficients represent the sum of the coefficients on the lead, lag,
and current independent variable. The null hypothesis of perfect market integration is strongly
rejected for all the twins in the sample. The cumulative coefficient on Index1, the domestic
market index of the country of the first part of the twin is highly statistically significant for 11
out of 13 twins, while the market index of the country of the second part of the twin, Index2,
shows up significantly for every single twin. All signs of the domestic market indices are as
predicted by the location of the trade effect reported by Froot and Dabora (1999). A positive
shock in the market index of country 1 leads to an increase in the relative price of twin A.
Whether this implies that the deviation from theoretical parity increases or decreases depends
on whether the price differential was positive or negative. A positive shock in the market
index of country 2 leads to an increase of the relative stock return of twin B.
The economic importance of the market index effect is considerable, as the
coefficients on the domestic market indices are remarkably high. The coefficient on Index1
varies between 0.071 for Smithkline Beecham and 0.667 for ABB. The coefficient on Index2
ranges from �0.145 for Eurotunnel to �0.866 for Brambles. This implies, for example, that an
one-percent increase in the Swiss Performance index increases the relative return of ABB AG
versus ABB AB with 67 basis points and an one-percent increase in the FTSE Allshare index
decreases the relative return of Brambles Industries Ltd versus Brambles Industries PLC by
more than 85 basis points. The coefficients on the domestic stock market indices are similar to
those reported by Froot and Dabora. The location of the trade effect is able to explain a
considerable part of the daily variation of relative twin returns. The R2 indicates that 10 to 40
percent of daily return differentials can be explained by the lagged dependent variable, the
local stock market indices, and the exchange rate.
12
The log deviations from parity of all twins (except Brambles) exhibit a statistically
significant first-order autoregressive component. The coefficient on the lagged dependent
variable is substantial and remarkably similar across twins. The fact that the coefficient is
negative suggests that return differentials display some kind of mean reversion. A positive
shock in the return deviation at date t will lead to a decline in the return differential at date t+1
of 5 to 40 basis points. This implies that the long-run sensitivities of the return differentials to
shocks in the local market indices are 5 to 40 percent smaller that the short-run sensitivities
presented in Table 5. Consequently, the location of the trade effect detected at the daily
frequency seems to persist over longer return horizons. Again, our results resemble the
findings of Froot and Dabora, who estimate the first-order autocorrelation of the return
differential to be approximately -0.20. The Durbin-Watson statistic is very close to 2 for all
twins, indicating that there is no significant serial correlation in the error term. This signifies
that the autoregressive model specification is correct. The estimated coefficient on exchange
rate changes is large and highly significant for most twins.10
6. Conclusions
Dual-listed companies (or Siamese twins) have been around for almost a century, starting with
Royal Dutch Petroleum and Shell Transport and Trading in 1907. In 1930, Unilever NV and
Unilever PLC were created. They remained the only two such firms until ABB AB and ABB
AG were formed in 1988, followed by the public offering of shares in Eurotunnel as well as
the creation of Smithkline Beecham in 1989. The 1990s saw the creation six more DLCs. In
the 21st century, there have been two, with one more near completion. In total, 13 DLCs have
been created. Interestingly enough, six have been collapsed into a single corporate structure.
A DLC is created by the de facto merger of two firms with different countries of
incorporation. Each firm retains its own separate legal identity and its own set of shareholders,
but is able to use the DLC structure to combine their operations. This is done by a set of
arrangements that are designed to insure that the business is operated as if were a single
company. As part of the legal contracts, the shareholders of each company will get dividends
based on a prescribed sharing of the cash flows created by the whole enterprise. In integrated
and efficient equity markets, the stock prices of the twins should move together perfectly, as
the stocks of both parent companies are perfect substitutes.
10 The small coefficient on the log returns of the exchange rate between British pound and the U.S. dollar for Smithkline Beecham can be explained by the fact the both the H and the E shares are traded in dollars.
13
This paper studies the mispricing of all 13 known DLCs. We find that the relative
prices of all twins exhibit statistically significant and economically substantial deviations
from theoretical parity. Average absolute price differentials range from around 2.5 to almost
12 percent, while maximum deviations reach values of 15 to nearly 50 percent. The deviations
from parity show substantial deviation over time, assuming both negative and positive values
for 11 out of 13 twins. Standard deviations are very high for all twins. This indicates that
important mispricing exists in DLCs, suggesting that arbitrage may be hampered due to noise
trader risk.
We show that while relative twin prices seem to display some mean reversion, we
cannot reject the hypothesis that price disparities follow a random walk for 6 DLCs in the
sample. Following Froot and Dabora (1999), we analyze whether return differentials can be
explained by movements in the domestic market indices of the countries of domicile of the
twins. We find that the relative return of a twin is strongly affected by fluctuations in the
domestic market indices. The magnitude and sign of the coefficients on broad market indices
are remarkably consistent across twins and generally highly statistically significant. 10 to 40
percent of the historical variation in daily return differentials can be explained by the lagged
dependent variable, the local stock market indices, and the relevant exchange rate. This
suggests that the location of the trade matters for the pricing of DLCs, which is at variance
with integrated and efficient stock markets.
In the next draft of this paper we will include an analysis of the unification of six
DLCs. In case of unification, the firm obtains a single main listing and eliminates the DLC
structure. Unifications are recent phenomena and have not been investigated in previous
studies. The first unification took place in 1996, while the 5 other twins have been collapsed
into a single corporate structure after 1999. At the announcement of the unification the
horizon for arbitraging is no longer infinite. This implies that noise trader risk is less likely to
obstruct arbitrage. Therefore, we expect that prices will converge to the theoretical price
ratio very rapidly. We investigate prices and returns, as well as volumes and bid-ask spreads
in these events. Preliminary work shows that convergence to parity occurs rapidly. This
suggests that the mispricing before the announcement of the unification persisted because
arbitrageurs faced an infinite horizon. Our analysis corroborates Shleifer and Vishny�s
(1997) model of limited arbitrage.
14
References
Black, Fisher, 1986, Noise, Journal of Finance 41, 529-543.
Brauer, Greggory A., 1984, �Open-ending� closed-end funds, Journal of Financial Economics
13, 491-507.
Brickley, James A., and James S. Schallheim, 1985, Lifting the lid on closed-end investment
companies: a case of abnormal returns, Journal of Financial and Quantitative Analysis
20, 107-117.
De Long, J. Bradford, Andrei Shleifer, Lawrence H. Summers, and Robert J. Waldmann,
1990, Noise trader risk in financial markets, Journal of Political Economy 98, 703-
738.
Froot, Kenneth A., and Emil M. Dabora, 1999, How are stock prices affected by the location
of trade?, Journal of Financial Economics 53, 189-216.
Lee, Charles, Andrei Shleifer, and Richard Thaler, 1991, Investor sentiment and the closed-
end fund puzzle, Journal of Finance 46, 75-110.
Pontiff, Jeffrey, 1996, Costly arbitrage: evidence from closed-end funds, Quarterly Journal of
Economics 111, 1135-1152.
Rosenthal, Leonard, and Colin Young, 1990, The seemingly anomalous price behavior of
Royal Dutch/Shell and Unilever N.V./PLC, Journal of Financial Economics 26, 123-
141.
Rubinstein, Mark, 2001, Rational markets, yes or no? The affirmative case, Financial
Analysts Journal, 15-29.
Thaler, Richard H., 1999, The end of behavioral finance, Financial Analysts Journal, 12-17.
Shleifer, Andrei, and Robert W. Vishny, 1997, The limits of arbitrage, Journal of Finance 52,
35-55.
Welch, Ivo, 2000, Views of financial economists on the equity premium and on professional
controversies, Journal of Business 73, 501-537.
15
Table 1 Description of the twins
DLC Country 1 / Country 2 (time diff.1)
DLC type
Merger Date
Unification Announced
Unification Date2
Royal Dutch / Shell Netherlands / United Kingdom (-1)
Combined Entities Structure 02.15.1907 − −
Unilever Netherlands / United Kingdom (-1)
Separate Entities Structure ??.??.1930 − −
ABB Switzerland / Sweden (0)
Combined Entities Structure 01.01.1988 02.04.1999 06.25.1999
Eurotunnel France / United Kingdom (-1)
Stapled Stock Structure 04.18.1989 − −
Smithkline Beecham United Kingdom / United States (-6)
Stapled Stock Structure 07.26.1989 02.20.1996 04.12.1996
Fortis Netherlands / Belgium (0)
Combined Entities Structure 12.12.1990 08.28.2000 12.14.2001
Elsevier / Reed International Netherlands / United Kingdom (-1)
Combined Entities Structure 01.01.1993 − −
Rio Tinto Australia / United Kingdom (-10)
Separate Entities Structure 12.21.1995 − −
Dexia France / Belgium (0)
Combined Entities Structure 11.19.1996 09.19.1999 11.26.1999
Merita / Nordbanken Finland / Sweden (-1)
Combined Entities Structure 12.15.1997 09.20.1999 03.24.2000
Zürich Allied / Allied Zürich Switzerland / United Kingdom (-1)
Combined Entities Structure 09.07.1998 04.17.2000 10.13.2000
BHP Billiton Australia / United Kingdom (-10)
Separate Entities Structure 06.29.2001 − −
Brambles Industries Australia / United Kingdom (-10)
Separate Entities Structure 08.07.2001 − −
1 Time differential between the two countries in hours. 2 Last trading day before unification.
16
Table 2 Summary Statistics of the log deviations from parity (in %)
This table shows summary statistics of the log deviations from parity for all 13 dual-listed companies (DLCs) in the sample. The columns present the mean, the mean of the absolute value, the standard deviation, the minimum, and the maximum value of the log deviations from parity (expressed in %) as well as the percentage of days in the sample period on which the log deviation was positive. For the unified DLCs the sample period ends 20 trading days before the unification announcement.
DLC Mean Abs StDv Min Max % pos
Royal Dutch / Shell 01.01.80−10.03.02 0.86 10.04 12.71 -36.22 19.83 68.5
Unilever 01.01.80−10.03.02 1.16 8.99 11.41 -39.07 29.10 62.2
ABB 01.01.88−01.07.99 -4.20 11.94 14.20 -48.77 17.77 45.2
Eurotunnel 04.18.89−10.03.02 -1.65 2.60 2.78 -10.87 17.67 25.7
Smithkline Beecham 07.26.89−01.22.96 7.94 8.10 4.09 -2.22 15.97 92.8
Fortis 12.12.90−07.31.00 -2.64 4.56 4.90 -17.10 13.79 30.5
Elsevier / Reed International 01.01.93−10.03.02 2.15 8.88 9.20 -14.73 17.58 55.6
Rio Tinto 12.21.95−10.03.02 1.90 4.11 4.76 -16.42 11.31 37.5
Dexia 11.19.96−08.20.99 -9.22 9.33 3.67 -17.66 5.15 1.8
Merita / Nordbanken 12.15.97−08.23.99 -7.01 7.07 3.19 -15.11 2.03 3.2
Zürich Allied / Allied Zürich 09.07.98−03.20.00 11.93 11.93 3.47 1.36 21.00 100
BHP Billiton 06.29.01−10.03.02 7.09 7.09 2.26 1.14 18.45 100
Brambles Industries 08.07.01−10.03.02 8.45 11.32 11.32 -18.62 29.15 74.3
17
Table 3 Test statistics
This table shows test results of three different t-tests for all 13 dual-listed companies (DLCs) in the sample. The first column reflects test statistics for the test that the mean the log deviation from parity equals zero over the sample period. The second column shows test statistics for the test that the mean total returns of both twins in local currency are equal over the sample period. The third column depicts tests statistics of the test that mean total returns are equal when expressed in a common currency. For the unified DLCs the sample period ends 20 trading days before the unification announcement. The 95% 2-tail critical value of the t-tests is equal to 1.96
DLC T-Test: Mean Log
Deviation from Parity Equal to Zero
T-Test: Equality of Mean Returns local currency
T-Test: Equality of Mean Returns
common currency Royal Dutch / Shell 01.01.80−10.03.02 5.24 -0.20 0.028
Unilever 01.01.80−10.03.02 7.83 -0.15 -0.011
ABB 01.01.88−01.07.99 -15.86 0.19 0.451
Eurotunnel 04.18.89−10.03.02 -35.16 -0.0034 0.018
Smithkline Beecham 07.26.89−01.22.96 78.63 0.074 −
Fortis 12.12.90−07.31.00 -26.99 0.36 0.44
Elsevier / Reed International 01.01.93−10.03.02 11.80 0.41 0.045
Rio Tinto 12.21.95−10.03.02 -16.76 0.26 -0.074
Dexia 11.19.96−08.20.99 -67.37 -0.13 -0.10
Merita / Nordbanken 12.15.97−08.23.99 -46.17 -0.088 -0.056
Zürich Allied / Allied Zürich 09.07.98−03.20.00 68.88 0.61 0.32
BHP Billiton 06.29.01−10.03.02 56.89 0.14 0.065
Brambles Industries 08.07.01−10.03.02 13.00 -0.63 -0.70
18
Table 4 Unit root tests
This table shows Augmented Dickey-Fuller test results for a unit root in the log deviations from parity for all 13 dual-listed companies (DLCs) in the sample. The augmented Dickey-Fuller regression includes a trend and four lags of the first difference of the log deviations from parity. The final column reflects whether the coefficient of the lagged log deviations from parity is statistically significance at the 5% level (based on the MacKinnon critical value of -3.413).
DLC Coefficient ADF Test Statistic Result
Royal Dutch / Shell 01.01.80−10.03.02 -0.0042 -2.726 Fail to reject unit root
Unilever 01.01.80−10.03.02 -0.0120 -4.711 Reject unit root
ABB 01.01.88−01.07.99 -0.0145 -3.956 Reject unit root
Eurotunnel 04.18.89−10.03.02 -0.1303 -10.35 Reject unit root
Smithkline Beecham 07.26.89−01.22.96 -0.0238 -3.244 Fail to reject unit root
Fortis 12.12.90−07.31.00 -0.0376 -5.839 Reject unit root
Elsevier / Reed International 01.01.93−10.03.02 -0.0060 -2.188 Fail to reject unit root
Rio Tinto 12.21.95−10.03.02 -0.0498 -4.565 Reject unit root
Dexia 11.19.96−08.20.99 -0.1035 -5.156 Reject unit root
Merita / Nordbanken 12.15.97−08.23.99 -0.0078 -2.903 Fail to reject unit root
Zürich Allied / Allied Zürich 09.07.98−03.20.00 -0.0762 -3.017 Fail to reject unit root
BHP Billiton 06.29.01−10.03.02 -0.4073 -5.679 Reject unit root
Brambles Industries 08.07.01−10.03.02 -0.0865 -3.070 Fail to reject unit root
19
Tab
le 5
L
og d
evia
tions
from
par
ity a
nd m
arke
t mov
emen
ts
This
tabl
e re
ports
regr
essi
on e
stim
ates
of t
he e
quat
ion:
()
tk
kt
kj
jt
ji
it
it
Bt
At
Bt
Are
Inde
xIn
dex
rr
rr
εδ
γγ
βα
++
++
−+
=−
∑∑
∑−
=+
−=
+=
+−
−
1
1
0
1
1 01
,1
,,
,..
21
,
whe
re A
and
B r
epre
sent
the
twin
pai
r, r A
,t an
d r B
,t ar
e th
e lo
g re
turn
s at
tim
e t o
f the
firs
t and
the
seco
nd p
art o
f the
DLC
in th
eir
loca
l cur
renc
ies,
resp
ectiv
ely
(Tab
le 1
�D
escr
iptio
n of
the
DLC
s� d
efin
es w
hat t
he fi
rst a
nd th
e se
cond
par
t is)
, Ind
ex1
and
Inde
x2 d
enot
e th
e lo
g re
turn
s of t
he d
omes
tic m
arke
t ind
ices
cor
resp
ondi
ng to
the
twin
A
and
twin
B, a
nd e
.r. re
pres
ents
the
log
chan
ges i
n th
e ex
chan
ge ra
te b
etw
een
the
curr
enci
es o
f the
firs
t par
t en
the
seco
nd p
art o
f the
twin
. Col
umns
dep
ict t
he tw
in, t
he sa
mpl
e pe
riod,
the
adju
sted
R2 , t
he D
urbi
n-W
atso
n sta
tistic
, the
deg
rees
of f
reed
om a
nd th
e cu
mul
ativ
e co
effic
ient
s on
all f
our i
ndep
ende
nt v
aria
bles
in th
e re
gres
sion
. For
the
unifi
ed
DLC
s th
e sa
mpl
e pe
riod
ends
20
tradi
ng d
ays
befo
re th
e un
ifica
tion
anno
unce
men
t. Fr
eque
ncy
is d
aily
. For
the
unifi
ed D
LCs
the
sam
ple
perio
d en
ds 2
0 tra
ding
day
s be
fore
th
e un
ifica
tion
anno
unce
men
t. a , b , c , r
efle
ct si
gnifi
canc
e at
the
10%
, 5%
and
1%
leve
l for
Wal
d te
sts t
hat t
he su
m o
f all
coef
ficie
nts (
lead
/lag
and
curr
ent v
alue
) equ
als z
ero.
D
LC
Sa
mpl
e pe
riod
R
2 D
W
DO
F L
agge
d de
p. v
ar.
Inde
x1
Inde
x2
e.r.
Roy
al D
utch
/ Sh
ell
01.0
1.80−1
0.03
.02
0.24
2 2.
03
5927
-0
.231
c 0.
346c
-0.5
01c
-0.8
06c
Uni
leve
r 01
.01.
80−1
0.03
.02
0.14
6 2.
06
5927
-0
.216
c 0.
170c
-0.5
60c
-0.5
95c
AB
B
01.0
1.88−0
1.07
.99
0.12
7 2.
02
2867
-0
.059
c 0.
667c
-0.4
84c
-0.4
30c
Eur
otun
nel
04.1
8.89−1
0.03
.02
0.13
7 2.
15
3501
-0
.329
c 0.
285c
-0.1
45b
-0.9
16c
Smith
klin
e B
eech
am
07.2
6.89−0
1.22
.96
0.13
2 2.
13
1527
-0
.296
c 0.
071b
-0.2
30c
0.03
8 Fo
rtis
12.1
2.90−0
7.31
.00
0.10
4 1.
99
2506
-0
.163
c 0.
476c
-0.5
37c
-0.5
80b
Else
vier
/ R
eed
Inte
rnat
iona
l 01
.01.
93−1
0.03
.02
0.19
7 2.
14
2534
-0
.319
c 0.
331c
-0.4
17c
-0.7
72c
Rio
Tin
to
12.2
1.95−1
0.03
.02
0.27
2 2.
15
1760
-0
.296
c 0.
431c
-0.7
41c
-0.5
24c
Dex
ia
11.1
9.96−0
8.20
.99
0.10
0 2.
18
708
-0.2
16c
0.29
0c -0
.324
c -0
.319
M
erita
/ N
ordb
anke
n 12
.15.
97−0
8.23
.99
0.24
6 2.
09
431
-0.3
71c
0.46
3c -0
.445
c -0
.139
Z
üric
h A
llied
/ A
llied
Zür
ich
09.0
7.98−0
3.20
.00
0.09
1 2.
03
390
-0.1
53c
0.15
5 -0
.354
b -0
.928
c B
HP
Bill
iton
06.2
9.01−1
0.03
.02
0.39
7 2.
21
319
-0.2
80c
0.45
9b -0
.709
c -0
.647
b B
ram
bles
Indu
stri
es
08.0
7.01−1
0.03
.02
0.28
8 2.
00
293
-0.0
05
0.34
3 -0
.866
c -0
.567
20
Figu
re 1
L
og d
evia
tions
from
par
ity
This
figu
re s
how
s on
a p
erce
ntag
e ba
sis
the
log
devi
atio
ns fr
om th
eore
tical
par
ity f
or a
ll 13
dua
l-lis
ted
com
pani
es (
DLC
s) in
the
sam
ple.
For
the
unifi
ed D
LCs
the
sam
ple
perio
d en
ds 2
0 tra
ding
day
s be
fore
the
unifi
catio
n an
noun
cem
ent.
Roy
al D
utch
/ Sh
ell
-50%
-40%
-30%
-20%
-10%0%10
%
20%
30% 1/
1/80
1/1/
831/
1/86
1/1/
891/
1/92
1/1/
951/
1/98
1/1/
01
Percent Deviation
Uni
leve
r
-50%
-40%
-30%
-20%
-10%0%10%
20%
30% 1/
1/80
1/1/
831/
1/86
1/1/
891/
1/92
1/1/
951/
1/98
1/1/
01
Percent Deviation
AB
B
-50%
-40%
-30%
-20%
-10%0%10%
20%
30% 1/
1/88
1/1/
901/
1/92
1/1/
941/
1/96
1/1/
98
Percent Deviation
Euro
tunn
el
-50%
-40%
-30%
-20%
-10%0%10
%
20%
30% 4/
18/8
94/
18/9
14/
18/9
34/
18/9
54/
18/9
74/
18/9
94/
18/0
1
Percent Deviation
21
Figu
re 1
− c
ontin
ued
Log
dev
iatio
ns fr
om p
arity
Th
is fig
ure
show
s on
a pe
rcen
tage
bas
is th
e lo
g de
viat
ions
from
theo
retic
al p
arity
for a
ll 13
dua
l-lis
ted
com
pani
es (D
LCs)
in th
e sa
mpl
e. F
or th
e un
ified
DLC
s the
sam
ple
perio
d en
ds 2
0 tra
ding
day
s be
fore
the
unifi
catio
n an
noun
cem
ent.
Smith
klin
e B
eech
am
-50%
-40%
-30%
-20%
-10%0%10
%
20%
30% 7/26
/198
98/
7/19
908/
19/1
991
8/28
/199
29/
10/1
993
9/22
/199
410
/4/1
995
Perecnt Deviation
Fort
is
-50%
-40%
-30%
-20%
-10%0%10
%
20%
30% 12
/12/
9012
/12/
9212
/12/
9412
/12/
9612
/12/
98
Percent Deviation
El
sevi
er /
Ree
d In
tern
atio
nal
-50%
-40%
-30%
-20%
-10%0%10
%
20%
30% 1/
1/93
1/1/
951/
1/97
1/1/
991/
1/01
Percent Deviation
Rio
Tin
to
-50%
-40%
-30%
-20%
-10%0%10%
20%
30% 12
/21/
9512
/21/
9712
/21/
9912
/21/
01
Percent Deviation
22
Figu
re 1
− c
ontin
ued
Log
dev
iatio
ns fr
om p
arity
Th
is fig
ure
show
s on
a pe
rcen
tage
bas
is th
e lo
g de
viat
ions
from
theo
retic
al p
arity
for a
ll 13
dua
l-lis
ted
com
pani
es (D
LCs)
in th
e sa
mpl
e. F
or th
e un
ified
DLC
s the
sam
ple
perio
d en
ds 2
0 tra
ding
day
s be
fore
the
unifi
catio
n an
noun
cem
ent.
Dexi
a
-50%
-40%
-30%
-20%
-10%0%10
%
20%
30% 11
/19/
965/
19/9
711
/19/
975/
19/9
811
/19/
985/
19/9
9
Percent Deviation
Mer
ita /
Nord
bank
en
-50%
-40%
-30%
-20%
-10%0%10
%
20%
30% 12
/15/
976/
15/9
812
/15/
986/
15/9
9
Percent Deviation
Zü
rich
Alli
ed /
Alli
ed Z
üric
h
-50%
-40%
-30%
-20%
-10%0%10%
20%
30% 9/
7/98
12/7
/98
3/7/
996/
7/99
9/7/
9912
/7/9
93/
7/00
Percent Deviation
BH
P B
illito
n
-50%
-40%
-30%
-20%
-10%0%10%
20%
30% 6/
29/0
19/
29/0
112
/29/
013/
29/0
26/
29/0
29/
29/0
2
Percent Deviation
23
Figu
re 1
− c
ontin
ued
Log
dev
iatio
ns fr
om p
arity
Th
is fig
ure
show
s on
a pe
rcen
tage
bas
is th
e lo
g de
viat
ions
from
theo
retic
al p
arity
for a
ll 13
dua
l-lis
ted
com
pani
es (D
LCs)
in th
e sa
mpl
e. F
or th
e un
ified
DLC
s the
sam
ple
perio
d en
ds 2
0 tra
ding
day
s be
fore
the
unifi
catio
n an
noun
cem
ent.
Bra
mbl
es
-50%
-40%
-30%
-20%
-10%0%10%
20%
30% 8/
7/01
11/7
/01
2/7/
025/
7/02
8/7/
02
Percent Deviation