The Limits of Arbitrage: Evidence from Dual-Listed Companies Abe de Jong Erasmus University Rotterdam [email protected] Leonard Rosenthal Bentley College [email protected] Mathijs A. van Dijk Erasmus University Rotterdam [email protected] 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 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 1 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). 2 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). 3 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.