Your Money: Grey market premium – A message for an IPO

Grey market premium is a function of investor sentiment and helps underwriters gauge the valuation of the IPO share and price it accordingly

IPO-PF3
Stock brokers in Munbai during the Finance Minister Nirmala Sitharaman presents her maiden Budget in Parliament today. Express Photo by Prashant Nadkar. 05.07.2019. Mumbai.

In the recent initial public offer (IPO) of Life Insurance Corporation of India, investors were confounded by the term ‘grey market premium’. Investors understand what green and red stand for in a stock market. But, in the context of IPOs, there exists another colour which is grey. Let us understand the grey market and associated terms such as grey market premium, kostak rate, and how investors should deal with it.

What is a grey market?

We all have heard about the black market where no guarantee or warranty is available on the products sold. Thus, the concept of parallel markets emerged because of the price difference and the consumers’ willingness to buy from unauthorized/unrecognized sellers. The primary market is the place wherein new shares and securities are sold to the investors through an initial public offering / offer for sale, and upon completion of IPO/ OFS, the shares are then traded in the stock exchanges such as BSE and NSE. The stock exchanges are regulated by SEBI, ministry of corporate affairs, etc.
There exists a small time gap between IPO / OFS and actual listing and trading of shares in the stock exchanges. This is where the concept of grey market and its premium comes into picture. The grey market is an unofficial market where individuals trade in IPO shares or applications before the shares are officially listed for trading in the stock exchanges. This market as such is not a marketplace or office wherein the trading occurs, it simply happens based on mutual trust and through word of mouth, and it is reaffirmed with an informal chit of paper.

It is an unofficial over-the-counter market, there are no regulations around it and all the transactions are carried out in cash. There are no written rules and regulations. Basically, in this juncture the trading of yet-to-be-sold shares happens. The grey market is not illegal but unregulated, meaning they are not bound by the regulations and there is no framework put forward by the regulating bodies such as the SEBI, stock exchanges, broking houses, etc.

Nuances of grey market premium

In simple terms, it is the price of the shares which are traded in the grey market. For instance, let us assume that ABC Co. is coming out with an IPO and Mr. A does not want to miss the opportunity to buy these shares. So, he approaches a person / broker Mr. B who is expected to have a certain lot of shares in the retail category. They both agreed to a price which is an initial IPO price plus a certain premium. So, here both the parties profit in one way or another, wherein Mr. A gets the shares and Mr. B gets monetary gain. The premium is the function of investor sentiment.

As in the above example, Mr. A was so sure about the company and did not want to miss the opportunity, so he does not mind paying a higher price to buy the shares. By determining the investors’ interest, investment bankers, underwriters would be able to gauge the valuation of the share and price it accordingly. In the context of the grey market, investors come across another term known as the ‘kostak rate’. Here, a person with a demat account is not interested in any IPO offering/listing profits and simply sells the right to apply for an IPO itself at a fixed rate called the ‘kostak rate’.

Investors and grey market premium

Even though the IPO market may be profitable, investors could often use the grey market premium as one among the many metrics to be used before subscribing to an IPO. However, it is always better to keep away from the grey market as it is unregulated and hence prone to manipulation, and no legal remedy is available. Further, the size of this market is too small and does not necessarily reflect the actual conditions.

The writer is a professor of finance & accounting at IIM Tiruchirappalli. With inputs from A Paul Williams, research staff at IIM Tiruchirappalli

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