What is Plain Vanilla
Plain vanilla signifies the most basic or standard version of a financial instrument, usually options, bonds, futures and swaps. Plain vanilla is the opposite of an exotic instrument, which alters the components of a traditional financial instrument, resulting in a more complex security.
BREAKING DOWN Plain Vanilla
For example, a plain vanilla option is the standard type of option, one with a simple expiration date and strike price and no additional features. With an exotic option, such as a knock-in option, an additional contingency is added so that the option only becomes active once the underlying stock hits a set price point.
Plain Vanilla Basics
Plain vanilla is a term to describe any tradable asset, or financial instrument, in the financial world that is the simplest, most standard version of that asset. It can be applied to specific categories of financial instruments such as options or bonds, but can also be applied to trading strategies or modes of thinking in economics.
For example, an option is a “contract that gives the buyer of that option the right, but not the obligation, to buy or sell an underlying asset at a specific price on or before a certain date.” A vanilla option is a regular call or put option but with standardized terms and no unusual or complicated features. Because, for instance, put options give the option to sell at a predetermined price (within a given timeframe), they protect against a stock going below a certain price threshold within that timeframe. The more specific rules regarding options, like most financial instruments, may have different styles associated with regions, such as a European-style option vs. an American-style option, but the term ‘vanilla’ or ‘plain vanilla’ can be used to describe any option that is of a standard, clear-cut variety.
In contrast, an exotic option is just the opposite, and involves much more complicated features or special circumstances that separate such options from the more common American or European options. Exotic options are associated with more risk as they require advanced understanding of financial markets in order to execute them correctly or successfully, and as such they trade over the counter. Examples of exotic options include binary or digital options, in which the payout methods differ in that they offer a final lump sum payout, under certain terms, rather than a payout that increases incrementally as the underlying asset’s price rises. Other exotic options include Bermuda options and Quantity-Adjusting options.
To point to another example of the use of plain vanilla, there are also plain vanilla swaps. Swaps are essentially an agreement between two parties to exchange sequences of cash flows for a predetermined period of time under terms such as an interest rate payment or foreign exchange rate payment. The swaps market is not traded on common exchanges but is rather an over-the-counter market. Because of this and the nature of swaps, large firms and financial institutions dominate the market with individual investors rarely opting to trade in swaps.
A plain vanilla swap can include a plain vanilla interest rate swap in which two parties enter into an agreement where one party agrees to pay a fixed rate of interest on a certain dollar amount on specified dates and for a specified time period. The counter-party makes payments on a floating interest rate to the first party for the same period of time. This is an exchange of interest rates on certain cash flows, and is used to speculate on changes in interest rates. There are also plain vanilla commodity swaps and plain vanilla foreign currency swaps.
Plain Vanilla in Context
Plain vanilla is also used to describe more generalized financial concepts. A plain vanilla card is a clear-cut credit card with simply defined terms. A plain-vanilla approach to financing is called a ‘vanilla strategy.’ Such a plain-vanilla approach was called for by many in the political and academic finance world after the 2007 economic recession due in part to risky mortgages that contributed to a tanked housing market. During the Obama administration, certain politicians, economists, and others pushed for a regulatory agency that would incentivize a plain-vanilla approach to financing mortgages, stipulating – amongst other tenets – that lenders would have to offer standardized, low-risk mortgages to customers.
Overall, in the wake of the 2007 global financial crisis, there has been a push to make the financial system safer and fairer. This mode of thinking is reflected in the passing of the Dodd-Frank Wall Street Reform and Consumer Protection Act in 2010, which also enabled the creation of the Consumer Financial Protection Bureau (CFPB). The CFPB enforces consumer risk protection in part through regulating financing options that call for a plain-vanilla approach.