6. DERIVATIVE LIABILITY

9 Months Ended

Sep. 30, 2012

In June 2008, the FASB issued authoritative guidance on determining whether an instrument (or embedded feature) is indexed to an entity’s own stock. Under the authoritative guidance, effective January 1, 2009, instruments which do not have fixed settlement provisions are deemed to be derivative instruments. As of September 30, 2012 the Company has two securities offerings that are subject to these provisions as follows:

The conversion feature of the Company’s Debentures, Amended Notes, related warrants, and May 2012 Notes (described in Note 5), do not have fixed settlement provisions because their conversion and exercise prices, respectively, will be lowered if the Company issues securities at lower prices in the future. The Company was required to include the reset provisions in order to protect the holders of the Debentures, Amended Notes, and May 2012 Notes from the potential dilution associated with future financings.

In accordance with the FASB authoritative guidance, the conversion feature of the Debentures, the Amended Notes and the May 2012 Notes was separated from the host contract (i.e., the Debentures, Amended Notes and May 2012 Notes) and recognized as a derivative instrument. Both the conversion feature of the Debentures, the Amended Notes, related warrants, and the May 2012 Notes have been characterized as derivative liabilities to be re-measured at the end of every reporting period with the change in value reported in the statement of operations.

At the date of issuance and as of December 31, 2011, the derivative liabilities were valued using Monte Carlo simulation model. As of September 30, 2012, the derivative liabilities were valued using a probability weighted average Black-Scholes pricing model with the following assumptions:

	September 30, 2012		At Date of Issuance		December 31, 2011
Conversion feature:

Risk-free interest rate		0.13%		0.19%		0.09%
Expected volatility		98.93%		98.14%		98.40%
Expected life (in years)		0. 5 years		1.0 year		.75 years
Expected dividend yield		0		0		0

Warrants:
Risk-free interest rate		0.25% - 0.60%		0.51%		0.54%
Expected volatility		79.3% – 93.41%		98.14%		105.30%
Expected life (in years)		2. 5 – 4.75 years		3.0 years		3.75 years
Expected dividend yield		0		0		0

Fair Value:
Conversion feature		1,885,926		649,463		263,984
Warrants		830,809		316,816		412,300
	$	2,716,835	$	966,279	$	676,284

The risk-free interest rate was based on rates established by the Federal Reserve Bank. The Company uses the volatility of five comparable guideline companies to estimate volatility for its common stock. The expected life of the conversion feature of the Debentures was based on the term of the Debentures and the expected life of the warrants was determined by the expiration date of the warrants. The expected dividend yield was based on the fact that the Company has not paid dividends to its common stockholders in the past and does not expect to pay dividends to its common stockholders in the future.

As of September 30, 2012 and December 31, 2011, the aggregate derivative liability of the conversion feature and the warrants was $2,716,835 and $676,284, respectively. For the nine months ended September 30, 2012, the Company recorded a change in fair value of the derivative liabilities of $1,074,272.

BALQON CORP. 10-Q