Introduction

In order to understand what a gray market premium is, an understanding of a gray market must first be established. Read on to understand what each of these terms encapsulates.

Defining a Gray Market

A gray market can be understood to be a market that operates on an unofficial basis and via which financial securities are bought and sold. Also known as a “grey” market, trading within the same ordinarily takes place in the following situations.

  • When a stock that’s been suspended begins to trade off the market
  • New securities are bought and sold prior to their official trading

With the aid of a gray market, it is possible for a company seeking to issue a stock in addition to their underwriters to assess what the demand for a new offering would be. This is because the gray market operates as a “when-issued” market. This means that it carries forth trade transactions pertaining to securities that will be made available via an offering in the near future.

While the gray market is an unofficial market, it is important to understand that it is not an illegal market.

When considering the term “gray market”, it is worth noting that it is meant to encapsulate the import and sale of commodities by dealers who are unauthorized. Once again, while this activity is carried out unofficially, it is not illegal.

Examining the Gray Market

While trading that occurs within the gray market is binding, the trades that are carried out are not capable of being settled up until the official trading for the security in question commences. Due to the nature of this market, unscrupulous parties may choose to renege on a trade transaction they got involved in. Owing to this element of risk, certain institutional investors ranging from pension funds to mutual funds may steer clear of partaking in gray market trading.

The gray market for commodities is particularly active and thriving in scenarios wherein there exists a prominent discrepancy in the price of a sought-after product in varied nations. Several nations in fact have a big gray market for consumer devices in addition to electronics that are popularly demanded owing to the fact that these goods can very well be bought online and can be shipped anywhere in the world.

The scope of gray markets expands beyond securities and basic goods and covers luxury cars, handbags and footwear, expensive clothing, cosmetics, pharmaceutical products, and cigarettes among other products. These markets are fueled by unauthorized dealers who may choose to import such products on a large scale, and while there might exist a healthy mark-up on the same, may choose to sell that at a price that falls below the prevailing price of the same in the local market.

Those who choose to avail of such products from unauthorized dealers described above due to the discounted price could experience problems with their purchases in the future. Prior to availing them, they should understand whether these products fulfill the local safety and certification stipulations in place. Moreover, as a result of purchasing their products via the gray market, customers may not be able to access post-sale service and support as dealers of these products may be unwilling to service goods bought via this channel.

On occasion, consumers may unintentionally avail of a gray market product. Indicators that can be used to assess whether a product has been purchased via a gray market include the price which may fall lower than the prevailing price enforced by local retailers. Moreover, user manuals for the product in question could be in a different language, could be photocopied and the CDs if provided could be duplicated copies.

Exploring Gray Market Premiums

Gray market premiums refer to the price at which security like a company’s stock is traded within a gray market. Take for instance the following example. The price of stock ABC amounts to INR 250. Now, if the gray market premium that prevails amounts to INR 450, it implies that investors and traders alike are willing to avail of the stock of company ABC for a price of INR 700 (i.e., INR 250 + INR 450).  Ordinarily, deals follow this pattern when carried forth in the gray market.

In order to examine the same concept with another example, consider the following. Acting as a trader in the stock market, X has been allocated 500 shares that have a specified issue price as a part of an upcoming initial public offering. Now, other investors, who are called ‘buyers’ in this scenario, imagine that the value of the share in question exceeds its issue price. These buyers are willing to pay a premium in order to avail of the shares in the gray market. Based on this scenario dealers that operate within the gray market then choose to reach out to investors like the aforementioned X who are recognized as ‘sellers’. The sellers and the dealers then collectively decide to set a deal in order to sell the seller’s shares at an outlined price called a premium, which exceeds the price of the stock’s issuance. Should X like the outlined deal and is unwilling to expose himself to risk in the form of the stock’s listing, he will sell his shares and generate a profit.

An IPO gray market premium (or IPO GMP) refers to the prevailing price – or premium, at which an initial public offering’s shares are made available for trade within a gray market.

Conclusion

Gray markets serve as unofficial, but legal markets. Ordinary investors can use the gray market as an indicative tool in order to discern how a stock would perform following its listing. Gray market premiums refer to the price via which a security is traded within the gray market.