The past few days I read about grey market premiums on Reliance Power IPO shares, how they went up, how they went down, and how they have been driving speculation about the listing prices. Last night I set about trying to understand what exactly this "grey market" is and how it works.
Grey market premium (or grey market price) is a premium amount at which IPO shares are being traded in Grey Market. This premium amount can be positive or negative depending on the demand and supply, i.e., the grey market price could be more than or less than the issue price. Generally there are two ways the grey market works:
Trading IPO allocated shares
An invester applied in the IPO and does not want to risk facing a listing price lower than the issue price. He decides to make a deal with a person who is ready to buy – a buyer at a fixed price. This price is the listing price +/- the grey market premium. E.g., Say issue price is Rs. 100. And premium is Rs. 40. Then the grey market price is Rs. 140. The seller is ready to sell his share for 140. Now when it gets listed, say it gets listed at Rs. 170 - seller makes profit of Rs. 30 per share. Now say the seller did not get any shares at all but he has already made a commitment so he will have to buy those shares from the market and give to the buyer.
Trading IPO applications
Another way is trading IPO applications. Here, the seller need not worry about the shares allotted to him in the IPO and the extent of gains. The retail investor is guaranteed a fixed rate of gain or Koshtak in exchange of selling their applications to the grey market operator. So, regardless of the listing price, the investor would get their application money plus the Koshtak. 'Kostak' is especially for people who do not want to take risk with IPO allotment or listing gains. Koshtak is usually very less than the grey market premium because grey market traders assume that the issue will be highly oversubscribed and not everyone will get allotment. So they pay less premium in expectation for that. Say maybe if the grey market premium is Rs. 300 for 20 shares lot size, they will give a premium of 2000 only thinking that only 1 in three applications will actually get shares.
The grey market has a big hub in Gujarat, especially Ahmedabad. The grey market is often used by companies to increase speculation about their IPO offerings. Increased grey market premiums are taken as a sign that the listing price will be high and therefore, it increases the investors' interest and often leads to oversubscription. Grey markets are also not regulated, all transactions are based on trust, there is no paper work. It is like a parallel stock market.
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