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Ratio Analysis

Ratio Analysis

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Published by: Mahesh Goyal on Mar 20, 2012
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RATIO ANALYSIS MEANING: Ratio Analysis: It is the relationship between two financial values.

To make it clear the word relationship stands for a financial ratio which is the result of two mathematical values. Uses:
  

It is useful to know whether the concern is making profit or loss. It is useful for making decisions in the management. Interpreting of financial statements. Classification of ratios:

1. Profitability ratios 2. Activity turn over ratios 3. Financial ratios a) Liquidity ratios b) Leverage ratios 1. Miscellaneous ratios Before going to ratios we need to know about what the current assets are & what the current liabilities are…… Current Assets:
      


Cash in hand Cash at bank Inventory (or) Stock Sundry debtors Bills receivable Investment (or) Securities Prepaid expenses (or) Income to be received

Fixed Assets:
     


Furniture & fixtures Tools and equipment Motor vehicles Plant & machinery Land & Buildings Lease hold premises

Intangible Assets:

Ø Trade marks

  

Ø Patents Ø Copy rights Ø Goodwill Current Liabilities:

     


Sundry creditors Bills payable Bank overdraft Outstanding expenses Provision for taxation Income received in advance

Long Term Liabilities:
  

Ø Mortgage loan Ø Bank loan Ø Loan from family members Profitability Ratios: Formulae’s: a) Gross profit ratio: Gross profit --------------- × 100 Net sales This ratio tells us the result from trading activity to know operating efficiency of the organization. b) Net profit ratio: Net profit ------------- × 100 Net sales It indicates the final result to organization and overall efficiency of the organization.

c) Operating ratio: CGS + operating expenses ---------------------------------- × 100 Net sales This ratio speaks of the operational performance of the organization and refers the managerial efficiency of the firm. Where, CGS = Sales – Gross profit (or)

Opening stock + purchases + manufacturing expenses – closing stock Operating expenses = Office Administrative Expenses + Selling & Distribution Expenses + Financial Expenses.× 100 Net Sales   Administrative office expenses ratio: Administrative office expenses --------------------------------------. d) Operating net profit ratio: 100 – Operating ratio Expenses ratios:  Cost of goods sold ratio: Cost of goods sold ------------------------.× 100 Net sales   Financial expenses ratio: .× 100 Net Sales Operating expenses ratio: Operating expenses ------------------------.× 100 Net Sales Selling & distribution expenses ratio: Selling & distribution expenses -------------------------------------.

operating expenses ---------------------------------.× 100 Shareholder’s fund g) Return on equity shareholder’s fund: Net profit after Interest.× 100 Capital employed (or) Return -------------. dividend -------------------------------------------------------.× 100 Net sales Non-operating expenses ratio: Non .× 100 Net sales e) Return on capital employed (or) Return on Investment (or) Rate of return Net profit ---------------------.× 100 Equity shareholder’s fund .Financial expenses ----------------------. Capital employed = Equity share capital + Preference share capital + Reserves & surplus + Fixed liabilities (Long term) – Fictitious assets. taxes & Pref. (or) Fixed Assets + Current Assets – Current liabilities. f) Return on shareholder’s fund: Net profit after taxes --------------------------.× 100 Investment  Where.

h) Earnings per share: (EPS) Profit available to Equity Shareholder’s -----------------------------------------------No. of equity shares i) Dividend per share: (DPS) Dividend on Equity Share Capital ----------------------------------------No.× 100 Market value per share k) Dividend pay-out ratio: (DPR) Dividend per equity shares --------------------------------Earnings per share l) Earnings yield ratio: (EYR) Earnings per share ---------------------------. of equity shares (or) Net profit after taxes .× 100 Market value per share m) Retained earnings ratio: Retained earnings -----------------------. of equity shares j) Dividend yield ratio: (DYR) Dividend per share ----------------------------.Preference share dividend ----------------------------------------------------------No.× 100 Total earnings Activity Turnover Ratio’s: Formulae’s: a) Stock turnover ratio: (or) Inventory turnover ratio: Cost of goods sold -------------------------------- .

Average Inventory at cost b) Debtors turnover ratio: (or) Receivable turnover ratio: Net credit sales ----------------------------------Average accounts receivable (Average account receivable = Debtors + Bills receivable) c) Creditors turnover ratio: (or) Payable turnover ratio: Net credit purchases --------------------------------Average accounts payable (Average accounts payable =creditors + Bills payable) d) Fixed assets turnover ratio: Net sales ---------------------Net Fixed Assets e) Current assets turnover ratio: Net sales ------------------Current Assets f) Total assets turnover ratio: Net sales ----------------Total Assets g) Working capital turnover ratio: Net sales --------------------------Net Working Capital Financial Ratios: Formulae’s: .

Quick assets = CA – Stock & Prepaid expenses Quick liabilities = CL – Bank overdraft c) Absolute liquid assets: Absolute liquid assets ---------------------------Current liabilities Where. (Absolute liquid assets = Quick assets) d) Debt equity ratio: Outsider’s fund -----------------------Shareholders fund .a) Current ratio: Current Assets -----------------------Current Liabilities b) Quick ratio: Quick assets --------------------Quick liabilities Where.

Where. Mortgage loans & Bank loan. f) Solvency ratio: (or) Total liabilities to total assets: Total Liabilities --------------------. Secured loans. Outsiders fund = Debentures. e) Proprietary ratio: Shareholders fund -----------------------Total Assets Where.× 100 Total Assets Miscellaneous Ratios: Formulae’s: a) Capital turnover ratio: Net sales ---------------------Capital employed b) Stock to current assets ratio: . Shareholders fund = Equity shareholders fund Preference shareholders fund R&S + P&L – Intangible assets Undistributed Profits.

May also be used to measure the ratio of return expected by investors.Stock ------------------Current Assets c) Inventory to working capital ratio: Inventory ---------------------Working Capital Other Important formulae’s: a) Profit earnings ratio: (P/E) Market value per share ----------------------------Earnings per share It is a measure for determining the value of a share.× 100 Sales It is a ratio between contribution and sales d) Margin of safety: (M/S) Total sales – Break-even point e) Capitalization method: Future maintainable profits Net Capital employed = -----------------------------------Normal rate of return . b) Break-even-point: (BEP) Fixed Cost -----------------------Profit volume ratio This a point at which there is no profit or no loss. c) Profit volume ratio: Contribution ----------------.

Debit note: It is the note prepared and sent to the supplier while returning the goods purchased on credit from him. Dual aspect concept: In every transaction. Credit note: It is the note prepared and sent to the customer after receiving the goods returned by him. Definition of Accounting: Accounting has been defined by the American Institute of Certified Public Accountants. the business is treated as a separate entity distinct from its owners and others. an asset is recorded in the books at the price paid to acquire it (Actual cost) and that this cost is the basis for all subsequent accounting for the asset. Cost concept: According to this concept. 6. more than this period reduces the utility of accounting data. 2. Business entity concept: According to this concept. both are recorded by debiting one accounts and crediting another account. a "The art of recording. in part at least. 5. . 3. transactions and events which are. 4. 5. 6. Principles of Accounting: a) Personal account: Debit the receiver Credit the giver b) Real account: Debit what comes in Credit what goes out c) Nominal account: Debit all expenses & losses Credit all gains & incomes Accounting process: Transaction Generation of Voucher Recording in Journal Posting into Ledger Generation of Trial Balance Trading & Profit & loss account Balance Sheet Concepts of Accounting: 1. Money measurement concept: This concept says that the accounting records only those transactions which can be expressed in terms of money only. there will be two aspects – the receiving aspect and the giving aspect. 2. intimating that his account is credited to that extent. and interpreting the results thereof". Going concern concept: According to this concept. Accounting period concept: It means the final accounts must be prepared on a periodic basis. This is called double entry. classifying and summarizing in a significant manner and in terms of money. 1. 4. it is assumed that a business has a reasonable expectation of continuing business at a profit for an indefinite period of time. 3. of a financial character. Normally accounting period adopted is one year. intimating that his account is debited to the extent.

7.7. 9.. Single Entry system: Under this system.e. Journal: The journal contains details of transactions (other than those relating to receipts or payments in cash or through bank). 10. only one aspect of each transaction is recorded. both aspects of each transaction are recorded. intimating that his account is debited to the extent. intimating that his account is credited to that extent. and unimportant information will be ignored in the preparation of the financial statement. Trail balance: A trial balance is a statement of debit and credit balances extracted from the various accounts in the ledger with a view to test the arithmetical accuracy of books. 3. This is a Nominal Account in its nature hence all the Trading expenses should be debited where as all the Trading incomes should be credited to Trading Account. Matching concept: The cost or expenses of a business of a particular period are compared with the revenue of the period in order to ascertain the net profit and loss. Accrual concept: The profit arises only when there is an increase in owner’s capital. Debit note: It is the note prepared and sent to the supplier while returning the goods purchased on credit from him. Credit note: It is the note prepared and sent to the customer after receiving the goods returned by him. Realization concept: According to these concepts. Gross profit or loss during the period. 8. which is a result of excess of revenue over expenses and loss. This is not a scientific method of accounting and is prone to error and manipulation.e. 2. i. 9. as per only important information will be taken. Disclosure: All information which is essential for fully understanding the financial statements should be disclosed in addition to the information required to be disclosed by law. 8. It contains all accounts of the business enterprise whether real. 1. The Balance of Trading Account will be considered as Gross profit (credit balance) or Gross loss (debit balance) and will be transferred to Profit and loss account. Consistency: Accounting practices should remain the same from year to year. personal. revenue is considered as being earned on the data which it is realized. Conservatism: Financial statements should be drawn up on a conservative basis i. This is the most scientific method of accounting and reduces the occurrence of errors and scope for manipulation. Materiality concept: It is a one of the accounting principle. 3. While preparing the Trading Account the following equation also can be used .e. Trading account: It is the account prepared to find out trading profit or loss of the business i. ensuring that the sum of all debits is equal to the sum of all credits.. the date when the property in goods passes the buyer and he become legally liable to pay. Ledger: Ledger is a set of accounts. 2. Double Entry system: Under this system. nominal.. recorded in chronological order. anticipated income should not be recorded where as likely losses should be provided for. Accounting Conventions: 1. 10.

Profit & Loss account: (P&L a/c) It is the Account prepares to find out net profit or loss of the business during the period. Bank Reconciliation Statement: (BRS) It is a statement reconciling the balance as shown by the bank pass book and balance shown by the cash book. Sales=Total (Cash + Credit) sales Cost of goods sold = Opening stock of goods = Purchases (Cash + Credit) less returns +Direct Expenses (-) Closing Stock of Goods.e. 4.. laps of time and accident. Hence all the other expenses and losses should be debited where as all the other incomes and gains should be credited to profit & loss account. 6. 8. Capital Expenditure: Any amount spent in increasing the earning capacity of a business is called as Capital Expenditure and includes Expenses like Purchase. Assets and Liabilities of a concern on a given date. 2. 3. 5. It is a statement (not an account) prepared by taking all the real accounts & personal accounts. Revenue Expenditure: . Gross Profit + Other incomes / gains (-) in Direct Expenses/Losses = Net Profit or Net Loss Balance sheet: (B/S) It is the statement prepared to find out financial Position i. This is a Nominal Account in its nature. Depreciation Methods: 1. Fixed installment method Diminishing balance method/ Written down value method Annuity method Depreciation/Sinking fund method Insurance Policy method Machine hour rate method Depletion method Revaluation method Capital Reserve: The reserve which transferred from the capital gains is called capital reserve. Depreciation: Depreciation denotes gradually and permanent decrease in the value of asset due to wear and tear. Installation and improvement of Fixed Assets and repayment of loans. technology changes. 7. While preparing Profit & Loss Account the following equation can be used. General Reserve: The reserve which is transformed from the normal profits of the firm is called general reserve. The balance of Profit & loss account will be considered as Net Profit (Credit Balance) or Net Loss (Debit Balance) and will be transferred to Capital Account.Sales less returns (-) Cost of Goods sold =Gross Profit or Gross loss.

Outstanding income: Outstanding income means income which has become due during the accounting year but which has not so far been received by the firm. Ex: Preliminary expenses. but not yet paid for. Debentures: (AS-6) When a company borrows money from investing people. Accrued income: Income earned during the current accounting year but has not been actually received by the end of the same year. rent. commission.. Shown on the asset side of a Balance sheet as an asset. Revenue Receipts: Any amount Received in the normal course of Business is called as Revenue Receipts and includes sale of goods. wages. Outstanding expenses: Outstanding expenses refer to those expenses which have become due during the accounting period for which the final accounts have been prepared but have not yet been paid. When accounts payable are paid off. Account payable: Money which a company owes to vendors for products & services purchased on credit. . Since the exception is that the liability will be fulfilled is less than a year.Any amount spent in earning Revenue/Profit is called as Revenue Expenditure and includes the Expenses like salaries. rent received. Advertisement expenses. repairs. raised by the way of loans and sale proceeds of fixed Assets is called as capital Receipt. it issues a bond which is stamped with the official seal of the company. Deferred Revenue Expenditure: The benefit of the expenditure will be differed to the future periods for which the expenditure is charges.  Debentures are the most common form of loan capital which is made available by investors on a long-term basis. interest. Differed revenue expenditure is known as asset in balance sheet. Capital Receipts: Any amount Received as investment by the owners. That means it is not related to one period but related to more than one period. Ex: Pension Fund Scheme. maintenance. discount. it represents the negative cash flow of the company. These bonds are called "Debentures". Accrued expenses: The expenditure which is incurred and the payment there of might or might not be paid. Prepaid expenses are to be deducted from such expenses in the debit side of profit and loss account. stores. Account receivable: Money owed by customers to another entity in exchange for goods or services that have been delivered or used. ranging from a few days to a year. Prepaid expenses: The amount paid for the expenditure relating to the future years. Receivables usually come in the form of operating lines of credit and are usually due within a relatively short time period. Deferred Revenue Income: Deferred revenue income which is income differed to the future periods. depreciation and materials etc.

2) A cash flow statement is merely record of cash receipts and disbursements. Fund flow statement: A statement that uses net working capital as a measure of liquidity position is referred to as funds flow statement. 4) Capital clause. It defines duties. It contains 1) Name clause. 1) Funds flow statement is concerned with change in working capital position between two balance sheet dates. Articles of Association: (AOA) This document represents rules and regulations of the company. Helps in making correct decisions in planning and development of the company Differences between cash flow & fund flow statement: Cash flow statement Funds flow statement 1) Cash flow statement is concerned only with the change in cash position. 5) Liability clause. It is a secondary document. 3) State clause.   Debenture holders will get fixed rate of interest. This document represents constitution of that company. it also opening and closing balance of cash.    Reveals the changes in the working capital and gives the details of the sources from which working capital has been financed.   It is useful for investors and creditors It provides vital information about the company’s ability to generate future cash flow to satisfy investors and creditors expectation. rights. It is repayable on a specific date. Helps in the analysis of the financial operations and explains causes for the changes on the liquidity position of the company. and regulations of the company between themselves and company Cash flow statement: (AS-3) Cash flow statement is a statement shows how much cash is generated and expensed in the organization during the year. Interest is payable whether company earns profits or not. 2) Objective clause. and 6) Situation clause. 3) A funds flow is the studying the solvency of a business one is interested not only in cash bal but also in the assets which are easily convertible into cash . Memorandum of Association: (MOA) It is the main document of the company. It subordinates to the act and it is must for every company.

4) Public ltd company starts its operations only after getting business commencement certificate (but not after incorporation). 5) Equity Shareholders are called RESIDUAL OWNERS of the company. 5) Public ltd company can go to public issue.Differences between equity shares & preference share holders EQUITY SHARES PREFERENCE SHARES 1) Equity Share Holders get Equity Shares of the Company. 4) Preference Share Holder. and there is no limit for maximum. 2) In private limited company there are minimum two members require to start its operations. 2) Preference shares which are carrying the preference rights. 3) In public ltd company minimum directors-3. Difference between Public Limited Co & Private Limited Co Public Limited Company Private Limited Company 1) Public limited co is a listed company at the stock exchange. 4) Private ltd company can start business after incorporation. Dividend is a fixed income to them. Irrespective of the Profit Making of the Company. 2) In public limited company there are minimum seven members require to start it operations. there dividend sharing will be high else it will be low. . They get dividend at a fixed rate. and maximum members are 50. 1) Private limited company is not a listed company at the stock exchange. If the company makes huge profits. 3) Preference Share Holders. 4) Dividends to Equity Share Holders is optional and at company's discretion. it is a right to get cumulative or non cumulative dividends from the company. 5) Private ltd company shall not issue shares to the outsiders. the Equity Share Holders get their share. 3) In private ltd company minimum directors-2. 5) Preference Share Holders get paid their dividends ahead of Equity Shareholders. 1) Preference Share Holders get Preference Shares. 3) Equity Shares are shares whose profit sharing depends on Profit Making of the Co. 2) Equity shares which are not having preference rights. After all the obligations of the company are over.

the NSE has developed into a sophisticated. IPOs are often risky investments.e. An FPO is essentially a stock issue of supplementary shares made by a company that is already publicly listed and has gone through the IPO process. The BSE list over 6000 companies & is one of the largest exchanges in the world. to raise resources to meet their requirements of investment. Close-ended fund: Close ended funds means it is open for sale to investors for a specific period. Initial Public Offering: (IPO) IPO stands for Initial Public offering. Every organization. India. pooled together by a large number of investors who give their money to a fund manager to invest in a large portfolio of stocks and/or bonds. The national stock exchange conducts transactions in the wholesale debt. at NAV related prices at anytime. equity & derivative markets. Mutual Fund: A mutual fund is made up of money i. Established in the year 1992. after which further sales are closed. The BSE has helped to develop the country’s capital markets.  Primary market: Primary Market is a channel for issuance of new securities. but often have the potential for significant gains. The securities may be in various forms such as equity or debt.. Both the primary market for existing securities is the part of capital market. The primary market is regulated by the Securities and Exchange Board of India (SEBI a government authority). Government as well as corporates. National Stock Exchange: (NSE) The National Stock exchange is India’s largest financial market. Open-ended fund: Open ended funds means investors can buy and sell units of fund.e. IPOs are often used as a way for a young company to gain necessary market capital. electronic market. preferred stock. Any further transaction for buying the units or repurchasing them. corporate as well as Government needs funds for further expansion. . Capital Market: The market for long term funds where securities such as common stock. in the secondary markets. including the retail debt market and helped to grow the Indian corporate sector. The shares are issued for the first time to the public as opposed to the secondary market. and bonds are traded. directly from the fund this is called open ended fund. For ex: unit 64. Follow on Public offering: (FPO) An issuing of shares to investors by a public company i.. Primary Market provides an opportunity to the issuers of the securities. which ranks third in the world for transacted volume. the BSE was established in the year 1875 as the Native share & stock brokers association based on Mumbai. happen.Bombay Stock Exchange: (BSE) Bombay stock exchange is the first and securities market in India. already listed on a stock exchange.

Capital employed: The term capital employed means sum of total long term funds employed in the business.(Share capital + reserves & surplus + long term loans – (non business assets + fictitious assets) Minority Interest: Minority interest refers to the equity of the minority shareholders in a subsidiary company. Bad debts: Bad debts denote the amount lost from debtors to whom the goods were sold on credit. Rectification of errors: It is the process of rectifying or correcting errors if committed any in the books of accounts. Amortization: The process of writing of intangible assets is term as amortization. Secondary market: Secondary Market refers to a market where securities are traded after being initially offered to the public in the primary market and/or listed on the stock exchange. A bond is a promise to repay the principle along with interest on a specified date. i.e. Venture capital: It refers to the financing of high risk ventures promoted by new qualified entrepreneurs who require funds to give shape to their ideas. issuer type. Bonds are often divided into different categories based on tax status. Fictitious assets: These are assets not represented by tangible possession or property. Suspense account: A suspense account is the account prepared to transfer difference in trial balance if any to be rectified in future. Bonds: A debt instrument issued for a period of more than one year with the purpose of raising capital by borrowing. maturity & secured/unsecured. debit balance in the profit and loss account when shown on the assets side in the balance sheet. Working capital: The funds available for conducting day to day operations of an enterprise. Examples of preliminary expenses. . discount on issue of shares. Also represented by the excess of current assets current liabilities. Majority of the trading is done in the secondary market. Secondary market comprises of equity market and the debt markets. credit quality.

NPV: The net present value of an investment proposal is defined as the sum of the present values of all future cash inflows less the sum of the present values of all cash out flows associated with the proposal. IRR: Internal rate is the rate at which the sum total of discounted cash inflows equals the discounted cash out flow. from financial institutions (called factor). dominated in us dollars that represent a non-US company publicly traded in local currency equityshares. Or decision-making with regard to investment of money in long term projects. Joint Venture: A joint venture is an association of two or more the persons who combined for the execution of a specific transaction and divide the profit or loss thereof an agreed ratio. GDR: (Global depository receipts) A depository receipt is basically a negotiable certificate. ADR: (American depository receipts) . Capital budgeting: Capital budgeting involves the process of decision making with regard to investment in fixed assets. Partnership: Partnership is the relation b/w the persons who have agreed to share the profits of business carried on by all or any of them acting for all. Combined leverage: It is used to measure of the total risk of the firm = operating risk + financial risk. Financial leverage: It is nothing but a process of using debt capital to increase the rate of return on equity. Profitability index: Where different investment proposal each involving different initial investments and cash inflows are to be compared. Operating leverage: The operating leverage takes place when a changes in revenue greater changes in EBIT. ARR: Accounting or Average rates of return means the average annual yield on the project.Leverage: It is a force applied at a particular point to get the desired result. Payback period: Payback period represents the time period required for complete recovery of the initial investment in the project. Factoring: It is an arrangement under which a firm (called borrower) receives advances against its receivables.

and the actual results compared with the forecasted and planned ones. current of new allows for budget reductions and expansions in a rational manner and allows reallocation of source from low to high priority programs. Fixed budget: It is a budget which is designed to remain unchanged irrespective of the level of activity actually attained. DERIVATIVES Derivative: This derivative concept was introduced in India in the year 1992. Underlying assets:  Shares . Equivalently the value of a derivative changes when there is a change in the price of an underlying related asset. Cash budget: It is a summary statement of firm’s expected cash inflow and outflow over a specified time period. Master budget: A summary of budget schedules in capsule form made for the purpose of presenting in one report the highlights of the budget forecast. Budget: It is a detailed plan of operations for some specific future period. materials. Such receipts are to be issued in accordance with the provisions stipulated by the securities Exchange commission (SEC) of USA like SEBI in India. Derivative is product whose value is derived from the value of one or more basic variables of underlying asset. Zero-based budgeting: It is a management tool which provides a systematic method for evaluating all operations and programs.Depository receipt issued by a company in the USA is known as ADRs. labour. (or) A Derivative is a “financial contract whose value is derived from or depends on the price of some underlying asset”. i. Marginal costing: An additional cost which is involved for production of additional unit.e. Marginal cost: It is a technique of costing in which allocation of expenditure to production is restricted to those expenses which arise as a result of production. It is an estimate prepared in advance of the period to which it applies. Budgetary control: It is the system of management control and accounting in which all operations are forecasted and so for as possible planned ahead. and direct expenses and variable overheads.

. Swaps 1. Options: An option gives the holder of the option the right to do something. 1. cotton etc ) Bullion Stocks Bonds Currency Types of derivatives: Mainly there are four types of derivatives they are 1. Future contract 3. 2. in future contract maturity value is fixed on the rate of maturity date at market price. Future contract: A future contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price. 3. Forward contract: A forward contract is customized contracts between two entities were settlement takes place on a specific date in the future at today’s pre agreed price. Future contracts are standardized exchange traded contracts.      Securities Commodities ( food grains. 1. oils. Options a) Call option b) Put option 1. (or) It is an agreement between two parties for exchanging of underlying asset at a specific consideration amount at specified time period. Forward contract 2. The option holder option may exercise or not. 1. Put option: A put option gives the holder the right but not obligation to sell an asset by a certain date for a certain price. Call option: A call option gives the holder the right but not the obligation to buy an asset by a certain date for a certain price. The price of forward contract remains fixed till maturity. (or) It is an agreement between two parties for exchanging of underlying asset at a specific maturity date to the future maturity date market value.

4. Types of swaps:  Interest rate swaps: An interest rates swap is an agreement between two parties to exchange interest payment for a specific maturity for an agreed notional (principle) amount. . 1. Swaps: Swaps are private agreements between two parties to exchange cashflows in the future according to a pre-agreed formula. European option: This European option should be exercised only after the maturity date.  Currency swaps: It is an agreement between two parties for exchanging of two different currencies for a specified date along with exchange of principles. Bermuda option: This Bermuda option is an combination of both American & European option.American option: This American option should be exercised before the maturity date or earlier to maturity date.

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