Grey market premium (GMP) trading has emerged as one of the interesting nuances of financial markets especially when it is related to Initial Public Offerings (IPOs). The general idea of the grey market is quite different from the primary and secondary stock markets in many ways. Though GMP trading remains outside the official stock markets it is providing significant input into how the new stock will function when it finally makes its debut on the official platform.
In this in depth essay we will define and describe how grey market premium trading operates discuss its importance in the IPO process and the risks associated with it and go international for a clearcut perspective. Finally we’ll put it all into perspective by critically analysing whether GMP offers any meaningful insight into the very act of stock trading.
What is Grey Market Premium (GMP)?
The grey market in terms of financial markets is a market where securities or financial instruments are traded outside the official stock exchanges and not regulated by any administrative body. It usually is a pre market for IPOs where shares are sold before being issued on the stock exchanges.
Trades on the grey market are neither illegal nor fully regulated. Their grey legality area leaves transactions relatively unregulated by regulatory bodies such as SEBI Indias counterpart or SEC which is equivalent to the United States. Such lack of formal regulation opens opportunities but also places participants at huge risks.
Grey Market Premium (GMP) for IPO
Grey Market Premium is the premium or discount at which IPO shares are traded in the grey market. It reflects and forms an indicator of the view or mood of the market concerning the forthcoming IPO. If a company’s equity is expected to be priced at $100 during the IPO but it is trading at $120 in the grey market GMP is $20 which indicates high demand. On the other hand a grey market discount may suggest lukewarm interest.
Characteristics of GMP
Unregulated Trading
GMP trades are conducted outside of the floor of the official stock exchanges.
Indicator to IPO
The premium or discount is a preview of the market’s expectations about the IPO.
Indicator of Market Sentiment
The GMP reflects the general market sentiment regarding the IPO.
How Do GMP Premium Trading Function?
Function of Investors and Brokers
It is only between investors and brokerages in grey market premium trading. Here is how it works
Pre IPO Subscription
If the company intends to issue an IPO the investors are given a window of subscription to subscribe for the IPO shares. Normally this is the first step in the process.
Grey Market
Trade begins on the grey market prior to the listing of the shares on the exchange. Investors and traders start trading shares in the grey market based on expectations about how it will perform after the IPO.
Premium or Discount
As demand for the IPO becomes more visible the grey market sets a premium or discount. For example if the price band of a company’s IPO is fixed at $100 but investors feel that the stock will open at $120 then the GMP will express this optimism by tacking on a $20 premium.
What is OTC?
OTC stands for over the counter where the negotiations are made outside official exchanges. It is an informal agreement between brokers and investors. At this stage no physical movement of shares occurs. The parties only agree to settle the transactions once the stock is officially listed.
Redemption of Grey Market
When the IPO is listed on the stock exchange grey market trades are closed at the IPO opening price. If an investor buys a share at the premium rate in the grey market and the stock opens up more than expected then he gains. Otherwise if it opens down then he incurs a loss.
Example of Calculation of GMP
Hypothetical IPO
Issue Price $ 100 per share
Grey Market Price $130 per share
Grey Market Premium (GMP) $30 per share
In this scenario the grey market indicates high demand and market players assume the stock is going to be listed in the grey market at a premium over its issue price.
Grey Market Premium in IPOs
Market Sentiment Indicator
GMPs are perceived more often than not as a proxy for investor sentiment. A higher GMP often reflects the expectation of investors that the IPO would do all right in the market once it is listed with high demand and a positive reaction from the market. A low or negative GMP would often indicate very little interest and investors feel that the stock is going to do badly in the markets after listing.
For example if the GMP is quite high compared to the issue price retail and institutional investors may view the equity as a profit making investment and thus attract more subscriptions.
Investor Participation
Grey Market Trading
Grey market trading provides early investors with the opportunity to raise returns even before the actual listing of the stock. Here again it is being largely resorted to by HNIs and institutional investors who are capable of undertaking high risk exposures due to their high depth and breadth respectively.
GMP is also a critical basis upon which the decision to subscribe to an issue for a retail investor is made. Most consider good GMP as a cue to investment expecting an easy gain once the stock hits the list.
Book Building Process Pricing Insights
During the bookbuilding process of an IPO the underwriters and the company promoters fix a price range for their stock. Generally it has been observed that when there is a high GMP then the last price may sometimes be high. This is because when the underwriters perceive strong demand reflected in the grey market then they change the price band upwards.
Why Do Companies Care About GMP?
Since the companies are not directly involved in grey market trading GMP might affect the views on the prospect of the IPO. Higher GMP can create buzz about the stock and therefore may make people oversubscribe. This over subscription can make it a successful listing and give a good public image to the company.
Instead this may reflect weak demand and the stock may fail to deliver well on the listing day which would be harmful to the reputation of the company.
Risks Involved with Grey Market Premium
General Risks
Generally while the grey market premium provides an advanced indication of the stocks performance it incurs serious risks mainly because it is an illegal marketplace. Some of them include
Since the grey market is carried out in the shadow of regulatory authorities there are no official means of keeping the fraudulence practice from disgracing investors. In this case the households cheat manipulate prices or do anything that goes against their moral or professional code of conduct. This means more risk for the traders particularly the household investors who need more resources to validate the legitimacy of trades.
Volatility
In fact grey market premiums can swing wildly even literally overnight based merely on rumour shifts in market psychology or even social media and micro blogging. And to traders who rely far too heavily on GMP to indicate how an issue will perform when it lists and trades the upswings will be coupled with nasty downswings.
Counterparty Risk
In GMP trading there is a risk that the counterparty does not honour a deal on the official listing of the stock. These trades are informal and are based on mutual trust respectively so one may not settle if he deems the performance of the stock to be worse than expected.
Lack of Transparency
The grey market prices are determined informally and there is no central platform that records the grey market prices. Under such a scenario investors may be prone to making mistakes due to inadequate information concerning the prevailing GMP.
Potential Legal Consequences
Even though grey market trading is not illegal it occurs in a grey area and the participants are at the mercy of the local authorities if they decide to crack down on unregulated trading.
Determinants of Grey Market Premium
Company fundamentals
Firm float fundamentals are another crucial factor in determining GMP. In general a company with robust financials and growth prospects and a sound business model will attract more interest in the grey market and hence attract a higher GMP.
Market Sentiment
Grey market premium is highly vulnerable to broad market scenarios. GMP can be considerably higher during a bull market as the investors are likely optimistic about the IPO. On the other hand in a bearish market the GMP goes low due to weak investor sentiments.
Demand Supply Dynamics
The supply of shares and demand by investors directly affect the GMP. In the case of an oversubscribed IPO where demand far outstrips the supply of shares the GMP may rise. On the other hand in the case of an under subscribed IPO where there is weak demand the GMP could trend downwards or even go negative.
Reputation of Underwriter
The prestige of the investment banks or underwriters who manage the IPO also determines the grey market premium. An experienced and renowned underwriter may gain greater confidence from investors which leads to a higher GMP.
Anchor Investors
To this end the GMP is also quoted by institutional investors or anchor investors who invest in an essential quantity of the IPO before making a public offering. If they take a very high interest then the GMP tends to move upwards as the retail investors perceive the IPO to be well backed.
Industry Trends
Another aspect that may influence the GMP is the industry in which the company operates. A firm found within a high growth or fad industry such as in technology or renewable energy would command a higher GMP than firms found within more traditional industries.
Global Perspective on Grey Market Premium
Grey market trading does not have a country. It occurs extensively in many countries although it is of different relative importance. There are examples from some countries as follows
India
India is one of the most actively trading grey markets around the world especially with IPOs in mind. Retail investors in the country have lately increased participation in IPOs and GMP has become an important lead for estimating demand. In most instances good GMP values produced excellent listing day performances.
United States
Grey markets in the U.S. are found to be rare compared to India but they exist especially for smaller ones.
IPOs or niche sectors
Officially institutions especially the SEC keep an eye on stock trading however grey market trading can still happen in an informal way with brokers and high networth investors.
Europe
Grey market trading is more often practised in the United Kingdom than it is across the rest of Europe. The United Kingdom refers to this as the when issued trade. This happens before shares are fully listed and like in India these trades are more regulated compared to other grey market trades and help estimate what market sentiment is like.
Is Grey Market Premium a Good Indicator?
The million dollar question many investors ask is if the grey market premium can be a good predictor of an IPOs success. While the GMP does offer some early predictive power it certainly does not guarantee an outcome. Here are a few reasons why
Correlation Not Causation
High GMP often accompanies the performance of an IPO but never initiates one. Many weak high GMPs have disappointed the market during their IPO. Of course there are some with low or negative GMPs that surprised the investor greatly.
Market Sentiment Influence
GMPs are largely driven by irrationally communicated market sentiment. During a stock market bubble when the GMP of a firm is increased substantially in comparison to its fundamental value poor results would occur once the correction takes place in the market.
Short Term Focus
GMP trade generally indicates short term profits rather than long term ones. When investors look for short term gains the GMP increases despite the firm’s poor long term fundamentals. This means that a high GMP does not show long term value.
Volatility and Uncertainty
Grey markets are highly volatile and GMPs may change very rapidly based on rumours or shifts in market conditions. An investment decision solely dependent on GMP would result in huge losses during a period of high volatility.
Technological Impact on GMP Trading
Over the past couple of years technology has significantly evolved financial markets at large and the grey market in particular. Through digital information portals and mobile applications mobile applications have greatly benefited the trader with instant access to realtime information. They can trade much faster than they would have done before. Despite grey market trading remaining relatively unregulated tech driven brokerage firms have made it more accessible for investors to engage with such trades.
Online forums messaging apps and social media are also becoming hot spots for analysts who analyse potential IPOs. With this manifold speculation is also likely to occur in the grey market. Information through crowdsourcing is now at the investors disposal which affects GMP. Democratisation has made the grey market much more accessible but it also raises the perils of price manipulation and disinformation.
With the growing use of digital tools and therefore elevated access to information caution and verification of sources should be paramount for any trader involved in speculative trading.
Growing Obsession with Speculation
This growth in speculative trading especially among retail investors has seen a significant impact on the grey market. At times even very ignorant investors about the fundamentals of a company end up purely buying based on GMP trends and market sentiment. It creates speculative behaviour or lets the premiums go up without necessarily reflecting the underlying value of the company.
For example when the market is going bull hype created about popular sectors such as technology or clean energy can cause the IPO to fetch an artificially escalated GMP. Speculative trading has always been there in all financial markets but what is unique about the grey market is that in the absence of regulation and the absence of any official data hype tends to spread much faster across the market.”
Globalization GMP and Repercussions
Globalisation has pushed grey market trading out of the domestic borders. A connected world means that investors from one region can buy shares from an IPO taking place in another region for precisely the same reasons that influence local markets company fundamentals sector trends and overall market sentiment. For example international investors may interpret the grey market premium on an Indian or Chinese IPO as a measure of whether to invest in the stock.
This cross border flow of capital will then create a more dynamic grey market with premiums that reflect not only local investor sentiment but also global investor sentiments. Yet such globalisation also brings together more risk factors since investors may not be fully aware of the special regulatory political or economic factors exerting influence over foreign markets.
Behavioral Finance and the GMP Phenomenon
Behavioural finance would highlight the insights for why GMP trading often reveals more than rationally calculated concepts such as fear of missing out (FOMO) herd behaviour overconfidence and many psychological influences for which the investors often go by in grey market trading decisions. Because investors consider that the grey market price is too high they may think that an opportunity is being missed and hence speculate into the grey market without adequate research.
Herd mentality too can take the premiums to exaggerated levels because more traders follow the trend they follow thinking that the official listing of the stock would yield excellent returns. Behavioural biases can thereby take huge price swings in a grey market and eventually have very unpredictable outcomes when the stock is finally listed.
Conclusion
Grey market premium trading provides a glimpse into the world of IPOs and valuable insights related to investor sentiment before the listing of stocks. In fact for several investors more so in markets like India the GMP has become an important variable in investment decisions visàvis an IPO. Though it is still possible to indulge in GMP trading it certainly comes with risks. Grey markets are known to be unsystematic and thereby volatile with the possibility of spreading potential misinformation.
Thus investors must exercise extreme caution in stepping into GMP trading. Though some may find a sneak preview of what an upcoming IPO will deliver in terms of market performance within the grey market premium this would not necessarily make for an investment decision and must be weighed carefully against company fundamentals general market conditions and other factors.