Vanilla option
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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 these 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.
Conversely an exotic option is some instrument that is more complex than the current frame of reference. The term "third generation option" is also used to somewhat frequently - it is not clear exactly which other options would be placed in the first and second generations.