June 2007 Capital Adequacy Extension © Copyright 2007, CCRO. All rights reserved. Page 54 of 92 d1 = lnVo/D + (r + σ2V/2)*T σV * √T and d2 = d1 - σV√T From these equations, we will ultimately want to solve for N(-d2), as that is the risk neutral probability of default. Assuming we can obtain the current equity (Eo), equity volatility (σE), and debt level (D) of a particular company from market sources, we are left with the value of the assets (Vo) and asset value volatility (σV) as the unknowns. To help solve this, we utilize Ito’s lemma which provides the formula:22 σE Eo = N(d1) σV Vo (2) Now we have two formulas (equations (1) and (2)) and two identical unknowns within those formulas (Vo and σV), which can be solved simultaneously to determine the unknowns.23 See Insert 5.2 for an example of applying the Equity based approach. 22 Options, Futures, and Other Derivatives. 4th Edition. John C. Hull. Prentice Hall Inc. 2000. Pg 631. 23Ibid.