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OMAR EL AKKAD

Saturday, August 27, 2005

A weekly examination of the thinking behind a specific trade in the stock, bond, or currency markets.

Merrill Lynch analysts have come up with a convoluted way to profit from the ghastly operating situation at the largest auto parts maker in the United States.

The three-part trade involves buying Delphi Corp.'s bonds, selling puts for January, 2006, to take in income, and shorting a "strangle" for January, 2006, to take advantage of the stock price's limited upside and downside.

Delphi has been in bad shape this year. It has posted four straight quarters of losses, and executives warn that bankruptcy is possible.

Merrill Lynch believes bankruptcy isn't likely. Delphi recently drew $1.5-billion (U.S.) on its revolving credit facility, and that should give it enough cash to make it through 2006. But Merrill said if bankruptcy is only a slim possibility, so is the best possible case: a generous bailout by Delphi's former parent, General Motors Corp.

GM is unlikely to seek a full, and costly, solution to Delphi's problems because the auto maker's legal responsibility for a portion Delphi's liabilities effectively ends in September, 2007, the brokerage said.

"It therefore appears to us that the stock market is discounting a generous bailout for Delphi at current prices," Merrill Lynch said, and even if GM steps in to help Delphi, the market reaction would likely be positive but brief.

The brokerage is maintaining its "neutral" rating on Delphi's stock. However, it's raising the bond rating to a "speculative buy."

Merrill Lynch admits there is considerable downside to the bond story if Delphi does go bankrupt, but estimates a 15-per-cent chance of the company defaulting in the next year. Even if Delphi does file for bankruptcy protection, bonds are more compelling than a credit default swap, the brokerage said, because the implied recovery value -- a sort of break-even point for investors -- is lower for Delphi's bonds than for a CDS.

Because Merrill Lynch believes a deal with GM and the United Auto Workers would be inherently supportive of Delphi's stock price, it recommends selling puts for January, 2006, with a strike price of $2.50 to take in income. If the put is not exercised, investors earn a premium of about 30 cents per notional of stock, which annualizes to 11.3 per cent, according to the brokerage. If the put is exercised, investors purchase the stock at a lower price.

Finally, Merrill Lynch recommends shorting a January, 2006, "strangle" to take advantage of the stock's limited upside and downside. The strangle is made up of a short $7.50 strike call and $2.50 strike put, and earns investors a premium of about $1.20 per notional of stock, or 45 per cent annualized if the stock closes between those endpoints. The break-even points are $8.70 and $1.30, meaning the stock price would have to rise 40 per cent or drop 80 per cent for investors to lose money.

Yesterday, Delphi shares closed down 28 cents to $6.04 on the New York Stock Exchange.

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