High Return Investments

Vanilla option

In finance, a vanilla option is a type of derivative security. Though the
term is very widely used throughout the financial literature and the
financial markets it lacks a precise definition. Generally speaking a
vanilla option is a 'simple' option in some sense. e.g. a particular type of
option may be described as vanilla if it is well-established in the
financial markets and is easy to trade - vanilla options typically have good
liquidity at a wide range of strike prices and maturities. Pricing models
may also deliver closed-form solutions for the present value of vanilla
options. However the term the vanilla is almost always used in the context
where there is a more complex or exotic option being considered. Thus in one
context a particular instrument may be considered to be vanilla but exotic
in an other. A striking example is the following sequence of instruments
each of which is exotic compared to the previous one in the list but rather
vanilla compared to the next:

financial future --> interest rate swap --> european swaption --> bermudan
swaption --> rollercoaster bermudan swaption.

(Note the first two of this are instruments without optionality, the term
vanilla is applied to these too).

Calibration and hedging are key factors in determining which instruments are
called vanilla. For example a bermudan swaption may be hedged by a
collection of european swaptions. Thus a trader in the bermudan market will
likely think of european swaptions as the vanilla. Further a model developed
to price bermudan options may be calibrated (i.e. have its parameters
chosen) such that the model gives the same prices as those found in the
market for european swaptions. That is, the model takes the european prices
as given and uses them to determine a price for the more complex bermudan
product. Again the term vanilla describes the european swaptions and exotic
describes the bermudan.

Even with the above caveats there are instruments almost universally termed
vanilla in various markets. In the foreign exchange and stock markets the
most vanilla options are european call and put options. In the interest rate
market swaps and caps are the vanilla instruments, although the former does
not actually involve any optionality. European swaptions are sufficiently
liquid to be called vanilla. The credit derivatives market is less mature.
Here the three most traded instruments are total return swaps, credit
default swaps and credit spread options. These are widely expected to become
the mainstream vanilla products of the market in the coming years.

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