Investors were confused by the term ‘gray market premium’ in the recent initial public offering (IPO) of Life Insurance Corporation of India. Investors understand what green and red mean in the stock market. But, in the context of IPO, there is another color that is gray. Let us understand the gray market and related conditions like gray market premium, cost rate and how investors should deal with it.
What is a gray market?
We’ve all heard of the black market where there are no guarantees or warranties for the products sold. Thus, the concept of parallel market arises due to price differences and customers’ desire to buy from unapproved / rejected vendors. The primary market is the place where new shares and securities are sold to investors through an initial public offer / sale and after the IPO / OFS expires, the shares are traded on stock exchanges such as BSE and NSE. Stock exchanges are regulated by SEBI, Ministry of Corporate Affairs etc.
There is a short gap between the actual listing and trading of shares on IPO / OFS and the stock exchange. This is where the idea of the gray market and its premium picture comes into play. The gray market is an informal market where individuals trade in IPO shares or applications before the shares are officially listed for trading on the stock exchange. This market is not a market or office where trading takes place, it is based solely on mutual trust and word of mouth and is reaffirmed with an informal chit of paper.
It is an informal over-the-counter market, there are no rules around it and all transactions are done in cash. There are no written rules. Basically, at this juncture, the shares that are still sold are traded. Gray markets are not illegal but unregulated, meaning they are not regulated and have no structure put in place by regulatory bodies such as SEBI, stock exchanges, broking houses, etc.
The subtlety of the gray market premium
Simply put, it is the price of shares traded on the gray market. For example, we assume that ABC Co. Coming up with an IPO and Mr. A does not want to miss the opportunity to buy these shares. So, he contacted Mr. B, a person / broker who is expected to have a certain lot of shares in the retail sector. They both agreed to an initial IPO price and a fixed premium. So, here both parties benefit in one way or another, where Mr. A gets shares and Mr. B gets financial benefits. Premium is the work of the investor’s feelings.
As in the example above, Mr. A was so confident about the company and did not want to miss the opportunity, so he did not mind paying a higher price to buy the shares. By determining the interest of investors, investment bankers, underwriters will be able to evaluate the shares and determine the price accordingly. In the context of the gray market, investors come across another term known as ‘cost rate’. Here, a person with a demat account is not interested in any IPO offer / listed profit and only sells the right to apply for an IPO at a fixed rate called ‘Cost Rate’.
Investors and Gray Market Premium
While the IPO market can be profitable, investors can often use the gray market premium as one of the many metrics used before signing up for an IPO. However, it is always best to stay away from the gray market because it is uncontrolled and therefore prone to manipulation, and no legal remedy is available. Further, the size of this market is very small and does not necessarily reflect the actual situation.
The author is a Professor in the Department of Finance and Accounting at IIM Tiruchirappalli. Research staff at IIM Tiruchirappalli, with input from A. Paul Williams