The recent upswing in the stock market, and success of some initial public offerings, set the grey market on fire.
And, many investors tend to fall prey to the premium being offered in it.
Ratan Gaikwad, for instance, made good money in 2007 by betting on a couple of IPOs where premiums were high. That was until he burnt his fingers on a big one -- the Reliance Power IPO in January, 2008.
Less than a month after listing, the stock for which Gaikwad paid Rs 430 a share was trading below Rs 200.
"Grey market premium is hogwash. It started as an illegal mechanism for the wealthy and institutional investors to garner more shares in IPOs that were oversubscribed multiple times.
"Nowadays, promoters, operators and even investment bankers float such trades to make an issue look attractive. The issue may not support the pricing, as we saw in power sector companies' IPOs at the beginning of the year," says a Kolkata-based broker.
A study of recent successful IPOs shows there is no mechanism in the price-discovery of grey market premiums. In SKS Microfinance's issue, the premium was a mere 0.51-0.71 per cent above the offer price.
However, since the listing, its share prices have run up from Rs 985 to Rs 1,383.50 -- a gain of 40.46 per cent.
On the other hand, a company like Indosolar, whose offer price is at Rs 29-32, has been given a premium of over nine per cent.
Besides, there are some companies like Ashoka Buildcon and V A Tech Wabag, which have not even announced their offer prices. But they are already commanding a hefty premium.
If one goes by subscription numbers, SKS Microfinance was subscribed 13.69 times, while Engineers India 13.36 times.
But the premium in Engineers India was higher at 3.63 per cent. Among recent issues, Eros International and Microsec Financial Services, which are expected to come up with their issues this month, are fetching a premium of Rs 29-30, though the companies have not yet announced their price bands.
Functioning
A high networth individual or institution -- expecting a stock will outperform the IPO price band -- uses brokers to arrange extra shares at a premium over the listing price.
These brokers, in turn, approach their prospective clients with the offer. On the day of the listing, a premium is paid in cash to the seller.
An example will make this clearer. Lets take a company that is coming up with an IPO and the allotment price is at Rs 100 a share.
The grey market premium is Rs 10 a share and a seller commits his stocks to a broker at that price.
On the listing day, the price of the stock moves between Rs 103 and Rs 105, and closes at the higher band. The buyer pays the seller Rs 5 in cash through the broker.
In case the share price closes at Rs 120, higher than the premium price, the seller pays the buyer Rs 10 in cash. That's because the buyer pays the difference between the closing price and the premium set, if the latter is lower.
The actual trading of shares may not happen. It is at the discretion of buyer and seller.
Premium amounts depend on demand for a stock's issue. Higher the oversubscription numbers, higher is the premium. "That's why the grey market trades peak a day or two before an issue opens," says Mukesh Dedhia, a certified financial planner.
Fundamentals
"When you are investing in an IPO, you need to look at why you are investing in the company, rather than the grey market premium," says Malhar Majumder, a certified financial planner.
Wealth managers say if an investor is indecisive about the future of an IPO, he should wait for the company to list. "The stock does not have a linear movement.
"Within a few weeks, the investor will definitely get the stock close to the issue price," says Suresh Sadagopan, a certified financial planner.
They also warn investors to restrain from getting into such trades by committing shares. These can backfire if an IPO does better than expected.
In such a case, the seller needs to pay cash to settle the trade, if the price of the stock goes over the decided premium.
"And, if you back out at the last moment, the broker can unethically use its power to recover the money. For example, it may block your demat and trading account until you reach a settlement," says a broker.
