Merrill Lynch trades derivative financial instruments and provides clients with customized derivative products. These transactions allow clients to manage their exposure to interest and currency exchange rate, equity and commodity price, and credit spread risks. Merrill Lynch also uses derivative instruments to manage its own risks related to its proprietary trading strategies, client transactions, and financing activities. See Notes 1, 3, and 5 to the Consolidated Financial Statements for a description of derivatives, accounting and valuation policies for derivatives, and further details on the role of derivatives in trading and financing activities.

Derivatives activities are conducted through a number of subsidiaries as part of client-driven and proprietary business transactions. Merrill Lynch Capital Services, Inc. ("MLCS") is Merrill Lynch's principal swaps dealer. Merrill Lynch Derivative Products AG, a "AAA" rated entity, is a swap subsidiary that provides credit intermediation for interest rate and currency swaps, options, and similar transactions between highly-rated or otherwise acceptable counterparties and MLCS. Various subsidiaries deal in currency derivatives, including certain banking subsidiaries and MLCS. Effective January 1997, Merrill Lynch International became the primary equity derivatives dealer for new business, replacing Merrill Lynch Capital Markets PLC. In connection with these derivative activities, certain of these subsidiaries purchase and sell securities for hedging purposes.

As a dealer, Merrill Lynch enters into derivative transactions to hedge certain inventory positions, including other derivatives. As an end-user, Merrill Lynch enters into interest rate, currency, or other derivative contracts with its derivatives dealer subsidiaries to hedge exposures arising from debt issuances. These subsidiaries then enter into contracts with third parties as part of Merrill Lynch's trading and risk management strategies.

Derivatives facilitate risk transfer and enhance liquidity in the marketplace. For issuers, derivatives may provide cost-effective funding alternatives, while for investors, derivatives may provide alternative investment options and the ability to hedge risk. Market participants include dealers, such as banks and other financial institutions, and end-users such as corporations, governments, pension funds, mutual funds, and other institutions.

Expanded market participation and competition have helped increase liquidity in conventional derivatives, such as interest rate swaps. Greater familiarity with, and increased understanding of the benefits of derivatives have also contributed to the continued development of complex products structured for specific clients. Increasing complexity and highly publicized losses, however, have led to concerns that these products possess greater risk to users and to financial markets. Although different in form, both derivative and cash instruments are subject to market, credit, and operational risks. Credit considerations, for example, exist for a corporate bond as well as an interest rate swap. In addition, both of these instruments are sensitive to market risk due to movements in interest rates that affect their respective pricing. The risks inherent in both types of instruments are managed in a manner consistent with a company's overall risk management policies (see Risk Management section).

Non-investment grade holdings and highly leveraged transactions involve risks related to the creditworthiness of the issuers or counterparties and the liquidity of the market for such investments. Merrill Lynch recognizes these risks and, whenever possible, employs strategies to mitigate exposures. The specific components and overall level of non-investment grade and highly leveraged positions may vary significantly from period to period as a result of inventory turnover, investment sales, and asset redeployment.

In the normal course of business, Merrill Lynch underwrites, trades, and holds non-investment grade cash instruments in connection with its investment banking, market-making, and derivative structuring activities. During the past year, non-investment grade trading inventories increased to satisfy growing client demand for higher-yielding investments, including emerging market and other non-U.S. securities. Non-investment grade securities have been defined as debt and preferred equity securities rated as BB+ or lower, or equivalent ratings by recognized credit rating agencies, certain sovereign debt in emerging markets, amounts due under various derivative contracts from non-investment grade counterparties, and other instruments that, in the opinion of management, are non-investment grade. Non-investment grade trading inventories are carried at fair value.

Merrill Lynch's insurance subsidiaries also hold non-investment grade securities that are classified as available-for-sale and are carried at fair value.

A summary of positions with non-investment grade issuers (for cash instruments) or counterparties (for derivatives in a gain position) follows:

Included in the preceding table are debt and equity securities and bank loans of companies in various stages of bankruptcy proceedings or in default. At December 27, 1996, the carrying value of such debt and equity securities totaled $133 million, of which 58% resulted from Merrill Lynch's market-making activities in such securities. This compared with $189 million at December 29, 1995, of which 66% related to market-making activities. In addition, Merrill Lynch held distressed bank loans totaling $351 million and $274 million at year-end 1996 and 1995, respectively.

Derivatives may also expose Merrill Lynch to credit risk related to the underlying security where a derivative contract can either synthesize ownership of the underlying security (e.g., long total return swap) or potentially force ownership of the underlying security (e.g., short put option). In addition, derivatives may subject Merrill Lynch to credit spread risk in that changes in the credit quality of the underlying securities may impact the derivatives' fair values. A summary of exposures related to derivatives with non-investment grade underlying securities follows:

Merrill Lynch engages in hedging strategies to reduce its exposure associated with non-investment grade positions by purchasing an option to sell the related security or by entering into other offsetting derivative contracts. Merrill Lynch also uses non-investment grade trading inventories, principally non-U.S. governments and agencies securities, to hedge the exposure arising from structured derivative transactions.

A summary of cash instruments and derivatives used to hedge the credit risk of non-investment grade positions follows:

Merrill Lynch provides financing and advisory services to, and invests in, companies entering into leveraged transactions, which may include leveraged buyouts, recapitalizations, and mergers and acquisitions. Merrill Lynch provides extensions of credit to leveraged companies in the form of senior and subordinated debt, as well as bridge financing on a select basis. In addition, Merrill Lynch syndicates loans for non-investment grade companies or in connection with highly leveraged transactions and may retain a residual portion of these loans.

Merrill Lynch holds direct equity investments in leveraged companies and interests in partnerships that invest in leveraged transactions. Merrill Lynch has also committed to participate in limited partnerships that invest in leveraged transactions. Future commitments to participate in limited partnerships and other direct equity investments will be determined on a select basis. A summary of loans, investments, and commitments related to highly leveraged transactions follows:

At December 27, 1996, no one industry sector accounted for more than 24% of total non-investment grade positions and highly leveraged transactions.