I’ve been following GM’s progress over the last six months, and I thought I would have a look at what the market thinks they will do over the next year

Firstly, looking at a simple pricing model for Credit Default Swaps (CDS) - the risk-neutral probability of default using a binomial model

γ₀= s₀/((1+r₀+s₀)*(1-RR))

where

s₀ = CDS premium

r₀ = Interest rates

RR = Recovery rate

Some assumptions:

• Interest rates are constant (not far off – U.S. interest rates are 4% and the curve is pretty flat),
• The CDS premium is constant over the year (curve is pretty flat, but slightly inverted).

Using

s0 = 1400bps (USD, MR restructuring)

r₀ = 4%

RR = 38%

Gives a value of 19.1%, so this tells us that in (simplified theory), the markets believe that GM has around a 1 in 5 chance of defaulting within the year.

This number seems very high - historical data suggests that the chance of a BB rated bond is around 1.3% and B around 6.6%

The article below investigates why that may be the case

http://www.bis.org/publ/qtrpdf/r_qt0312e.pdf

References:

Credit Derivatives  - Gunter Meissner - Page 104

http://www.amazon.co.uk/exec/obidos/ASIN/1405126760/qid=1144335586/sr=1-1/ref=sr_1_0_1/203-2251018-4885533

Attached spreadsheet: