Credit & Equity-Linked Strategy

Capital Structure ‘Arbitrage’A Tradable Dollars and Cents Approach

An IntroductionDecember 2003

Please refer to important disclosures on page 12 and Analyst Certification on page 11.

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A Tradable Relative Value Approach

� Credit and equity risk are unambiguously linked as the risk of debt holders notreceiving their claims is the risk of equity prices falling to zero.

� Both credit and equity risk are directly tradable with derivatives in themarketplace - credit default swaps and equity puts for instance. The closesimilarity between credit and equity derivatives has recently led the marketplace tosearch for any mis-pricing between these two asset classes.

� At the forefront of understanding the linkages between credit and equityvaluations are structural models such as KMV and CreditGrades which are basedon Merton, Black and Scholes academic work in the early 70’s on evaluatingcorporate liabilities. In short, these models use inputs from the equity market toevaluate credit instruments, however they do not seek to identify tradeopportunities that capitalize on the potential mis-pricing of credit and equityderivatives instruments.

� Our approach consists of searching the universe of liquid credit and equityderivatives in order to identify tradable long / short pairs where either the creditor equity risk may be mis-priced. Because credit and equity derivatives marketsoperate largely independently, this can easily lead to the relative mis-pricing of thetraded instruments.

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Correlation between Credit and Equity Risk

TRACERS CDS vs S&P 500 Option Implied VolatilityDaily Data from Apr 23, 02 to Oct 22, 03

CDS Pricing vs Option Implied Volatility As of Oct 22, 03

� The cost of ‘Credit Protection’ (measured by the pricing of Credit Default Swaps) correlateswith the cost of ‘Equity Protection’ (measured by equity option implied volatilities), on theaggregate over time (left chart) as well as cross-sectionally at one point in time (right chart).

� Neither relation is perfect, however, and credit and equity risk may be mis-priced relative toeach other.

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MO

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F

RCL

GP

BOW

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R2 = 46%

15%

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3-Year CDS

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TRACERS CDS

S&P 500 Implied Volatility

R2 = 85%

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Short CDS vs Long Equity Put: Trade Mechanics

� Searching for cases where the premia of a short CDS position exceed the cost of an equity putcredit hedge.

� Calculate the present value of CDS premia over the duration of the put option contract;the present value approach is used to address any potential timing mismatches between theCDSs, which most commonly trade with 5 year maturity, and the listed equity puts, where thelongest available expiration is currently Jan 06.

� Determine the potential CDS liability, i.e. ( 1 - Recovery ) x CDS Notional.

� Make an assumption what the stock price will be should debt default occur, e.g. $0.75which was the average price for former S&P 500 companies at the time of default.

� Determine the number of puts necessary to hedge the estimated credit risk, i.e. CDSLiability / ( Put Strike - Assumed Stock Price if Default).

� Determine the cost of the equity put credit hedge, i.e. Number of Puts x Put Ask Price.

� Two decision variables:

� Given a recovery assumption, does the present value of CDS premia over the life of theJan 06 option pay for the put hedge?

� What recovery value equates the cost of the put hedge to the present value of CDSpremia over the duration of the put option?

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Short CDS vs Long Equity Put: Screening for Opportunities

Example Calculations

Open Interest as an Option Liquidity Measure:91,082 contracts are outstanding, i.e. creditprotection worth $84,250,850 = 91,082 * 100 *($10.00 - $0.75) = Open Interest x Multiplier x(Strike Price - Default Stock Price Assumption).

Cost of Put Hedge:$7.46 = (1 - Assumed Recovery) *100 /(Strike Price - Assumed Stock Price ifDefault) * Put Ask Price = ( 1 - 40% ) * 100 /( $10 - $0.75 ) * $1.15.

Present Value of CDS Premia:The value of CDS premia over the duration ofthe put contract discounted by the libor rateand adjusted for the probability that the CDSpremia will not be received should defaultoccur.

Decision Variable 1:PV of the CDS premia exceeds the cost of theput Hedge by $1.50 (assuming 40% recovery).

Decision Variable 2:PV of the CDS premia equals the cost of a puthedge if recovery equals 27%.

assumed bid premium pvask open strike stock stock price price assumed through cost of pv cds break-even

ticker name price interest price price if default (bp) recovery Jan 06 put hedge - put hedge recoveryEIX Edison International 1.10 9,000 15.0 19.82 0.75 474 40% 9.61 4.63 4.98 --GM General Motors 0.50 7,934 10.0 41.88 0.75 191 40% 4.07 3.24 0.83 24%RJR RJ Reynolds 1.15 91,082 10.0 42.42 0.75 439 40% 8.96 7.46 1.50 27%MO Altria Group 0.90 1,732 15.0 45.30 0.75 212 40% 4.51 3.79 0.73 28%GP Georgia-Pacific 0.80 1,022 10.0 25.84 0.75 281 40% 5.89 5.19 0.70 31%BOW Bowater 1.75 24,480 20.0 41.75 0.75 288 40% 6.04 5.45 0.58 33%Selected Cases as of Oct 22, 03.

by recovery assumptionDescription Jan 06 Equity Put Hedge 3-Year CDS Put vs CDS

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Short CDS vs Long Equity Put: The Opportunity Set

CDS Premia through Jan 06 vs Equity Put Hedge CostAssuming 40% Recovery; Selected Cases as of Oct 22, 03

Break-Even Recovery ValuesSelected Cases as of Oct 22, 03

� Assuming 40% recovery, Edison International (EIX), General Motors (GM), RJ Reynolds(RJR), and Altria (MO), and are among the cases where the expected present value of CDSpremia through Jan 06 exceeds the cost of an equity put hedge.

� For Edison International (EIX), the break-even recovery is ‘negative’ as the present valueof CDS premia over the duration of the option contract exceeds the cost of the equity puthedge even under the zero recovery scenario.

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Present Value of CDS Premiums over Duration of Jan 06 Put Hedge ($)

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Short CDS vs Long Put: Advantages & Risks

Trade Opportunities

� The Put Option is an ‘Over-Hedge’

� The stock price can fall below the put strike without the occurrence of a creditevent that triggers a CDS liability. Thus the holder of the short CDS / long putposition could potentially obtain a put pay-off without being liable to pay out onthe CDS.

Trade Risks

� The most frequently traded CDSs have a 5 year maturity while the currently availablelongest dated listed put options expire Jan 05 or Jan 06. Any timing difference between 5-year CDSs and shorter dated puts leave investors at maturity of the puts with non-expired CDS positions. This creates the risk that the value of credit protection may rise bymaturity of the put while the put option is out-of-the-money.

Solutions

� Shorter dated CDSs can also be available, although CDS contracts with 5-yearmaturity are most commonly traded.

� Longer dated equity puts may be available in the over-the counter options market.

� At expiry (or over the duration) of the put contract, the short CDS position may bere-hedged with puts of later expiry.

� The trade may be unwound profitably before the put expiry.

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Short CDS vs Long Put: Advantages & Risks

Trade Risks (Continued)

� The stock price might not fall to (or below) $0.75 as assumed in the event that the shortCDS position triggers a liability.

Solutions

� A higher, more conservative stock price may be set when calculating the number ofputs used to hedge the credit risk.

� Equity put hedges based on options with higher strike prices are less sensitive tothe assumed ‘default’ stock price.

� The Present Value of CDS premia through option expiration is an expected value, butnot necessarily a realized outcome.

Solutions

� The present value calculations can be improved by studying the arrival ofcorporate liabilities (on Bloomberg via the DDIS function, for instance). Although thisshould improve the accuracy of the present value estimate, it is nonetheless subject toerror.

� In the even of credit default, it may take a long time to ‘recovery’ any claims on thecompany’s assets and the recovery value may be lower than expected.

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Alternative Capital Structure Models

Short CDS vs Long Equity Variance Swap

� An alternative to the short CDS / long put model to take advantage of ‘cheap’ equity risk.

� A long Variance Swap position generates cash in-flow (out-flow) should volatility increaseabove (decrease below) the set volatility strike.

� Should debt default occur, the stock’s realized equity volatility should increase and thus thelong Variance Swap position can offset the CDS liability.

� Should no default occur, one bears the risk that the realized volatility falls below the VarianceSwap strike. Such liability can however be offset by the cash-flow generated from the CDSpremia.

Buy-Write (Long Stock & Short Equity Call) vs Long CDS

� Taking advantage of ‘expensive’ equity risk.

� A buy-write consists of the simultaneous purchase of a stock and the sale of an out-of-the-money call option.

� The call premium may be used to finance multiple CDSs to protect the downside of the buy-write.

� The combined position allows for stock appreciation to the strike price of the call, while thedownside can be protected with the long CDS position.

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Other Capital Structure Models

Synthetic Convertible Bonds

Obtaining ‘cheap’ equity exposure with ‘expensive’ credit risk.

� A convertible bond is essentially (a) short a CDS, (b) long a risk-free asset, and (c) long a calloption and thus may be created synthetically.

� Though the correlation of credit risk and equity risk is significant (see page 3), for a givenlevel of credit risk, the cost of equity risk can vary substantially, i.e. one can identifycandidates where for similar downside risk (e.g debt default) one obtains the most upside viacalls.

Equity Put Ratio Spreads

� Taking advantage of steep equity put skew.

� The demand for credit protection via low strike puts has steepened the strike skew for manyequities, i.e. lower strike options have significantly higher implied volatilities than that higherstrike options.

� Equity put ratio spreads can take advantage of a steep strike skew by selling multiple farout-of-the-money put options for every near the money put option one is long (for instance, a6 x 1 ratio spread could consist of selling six $5 strike puts while buying one $30-strike put).Though a ratio spread requires a premium, the cost of the position is substantially reducedwhen the strike skew is steep. The option pay-off cannot be negative and reaches itsmaximum at the low strike put. Thus, holders of ratio spreads take the view that the stockprice will fall, but not collapse below the low strike put.

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Contact Information

Credit & Equity-Linked StrategyMichael Maras +44 20-7996-2510

Benjamin Bowler +1 212-449-3199

Yaw Debrah +1 212-449-0174

Heiko Ebens +1 212-449-1049

Equity Derivatives SalesMickey Strasser +1 212-449-3313

Credit Derivatives SalesDoug Mallach +1 212-449-6190

Analyst CertificationI, Heiko Ebens, hereby certify that the views expressed in this research report accurately reflect my personal viewsabout the subject securities and issuers. I also certify that no part of my compensation was, is, or will be, directly orindirectly, related to the specific recommendations or view expressed in this research report.

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Important Disclosures

MLPF&S or one or more of its affiliates acts as a market maker for the recommended securities to the extent that MLPF&S or such affiliate is willing to buy and sell such securities for itsown account on a regular and continuous basis: Genl Motors; Edison Intl; R.J. Reynolds; Altria Group. MLPF&S or an affiliate was a manager of a public offering of securities of thiscompany within the last 12 months: Genl Motors. An officer, director or employee of MLPF&S or one of its affiliates is an officer or director of this company: Genl Motors. MLPF&Sor an affiliate has received compensation for investment banking services from this company within the past 12 months: Genl Motors; Altria Group. MLPF&S or an affiliate expects toreceive or intends to seek compensation for investment banking services from this company within the next three months: Genl Motors; Edison Intl; R.J. Reynolds. MLPF&S togetherwith its affiliates beneficially owns one percent or more of the common stock of this company calculated in accordance with Section 13(d) of the Securities Exchange Act of 1934: GenlMotors; Edison Intl; R.J. Reynolds; Altria Group. Additional information pursuant to Section 34b of the German Securities Trading Act: Merrill Lynch and/or its affiliates was anunderwriter in an offering of securities of the issuer in the last five years: Genl Motors; Edison Intl; R.J. Reynolds. The analyst(s) responsible for covering the securities in this reportreceive compensation based upon, among other factors, the overall profitability of Merrill Lynch, including profits derived from investment banking revenues.

Futures and options are not appropriate for all investors. Such securities may expire worthless. Before investing in futures or options, clients must receive the appropriate risk disclosuredocuments. Investment strategies explained in this report may not be appropriate at all times. Costs of such strategies do not include commission or margin expenses.

In Germany, this report should be read as though Merrill Lynch has acted as a member of a consortium which has underwritten the most recent offering of securities during the last fiveyears for companies covered in this report and holds 1% or more of the share capital of such companies.

OPINION KEY: Opinions include a Volatility Risk Rating, an Investment Rating and an Income Rating. VOLATILITY RISK RATINGS, indicators of potential price fluctuation, are: A- Low; B - Medium; and C - High. INVESTMENT RATINGS, indicators of expected total return (price appreciation plus yield) within the 12-month period from the date of the initialrating, are: 1 - Buy (10% or more for Low and Medium Volatility Risk Securities - 20% or more for High Volatility Risk securities); 2 - Neutral (0-10% for Low and Medium VolatilityRisk securities - 0-20% for High Volatility Risk securities); 3 - Sell (negative return); and 6 - No Rating. INCOME RATINGS, indicators of potential cash dividends, are: 7 - same/higher(dividend considered to be secure); 8 - same/lower (dividend not considered to be secure); and 9 - pays no cash dividend.

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