Investments, tenth edition

  “Siamese Twin” Companies  

15

   

   In 1907, Royal Dutch Petroleum and Shell Trans-

port merged their operations into one firm. The two original companies, which continued 

to trade separately, agreed to split all profits from the joint company on a 60/40 basis. 

Shareholders of Royal Dutch receive 60% of the cash flow, and those of Shell receive 40%. 

One would therefore expect that Royal Dutch should sell for exactly 60/40  5  1.5 times the 

price of Shell. But this is not the case.  Figure 12.2  shows that the relative value of the two 

firms has departed considerably from this “parity” ratio for extended periods of time.  

 Doesn’t this mispricing give rise to an arbitrage opportunity? If Royal Dutch sells for 

more than 1.5 times Shell, why not buy relatively underpriced Shell and short sell over-

priced Royal? This seems like a reasonable strategy, but if you had followed it in February 

1993 when Royal sold for about 10% more than its parity value,  Figure 12.2  shows that 

you would have lost a lot of money as the premium widened to about 17% before finally 

reversing after 1999. As in Example 12.2, this opportunity posed fundamental risk.