What it means
The term borrows from ice cream, where vanilla is the basic flavour that other flavours are measured against. In finance, a plain vanilla product is the standard design that everyone recognises.
It is easier to understand, easier to price and easier to trade than a customised version, and it is the reference point for everything more complicated. Take a bond as an example.
A plain vanilla bond pays a fixed interest rate at regular intervals, repays the face value on a set maturity date and has no extra options attached. An unusual bond might let the issuer repay early, convert into shares or pay interest linked to a commodity price.
The same idea applies to options. A plain vanilla option gives the holder the right to buy (a call) or sell (a put) an asset at a set price on or before a set date.
Exotic options add conditions, such as switching on only if the price reaches a certain level. Plain vanilla products matter because they are the building blocks of the market.
They usually have many buyers and sellers, which makes them cheap to trade, and their prices are widely quoted. More complex products are often built by combining or altering vanilla pieces.
For a business, the choice between vanilla and exotic is a choice between simplicity and fit. A simple product is transparent and easy to value, but may not match a company's exact needs.
A tailored product may hedge a risk more precisely, but can be costly, hard to value and difficult to exit. Managers should be careful when offered something that is not vanilla.
They should ask what the extra features do, who benefits from them and how the product would behave in a bad scenario. If the answer is not clear, the plain version is often the wiser choice, even if it costs a little more.
In practice
Real-world examples.
Example
A small business borrows $200,000 from a bank on a plain vanilla loan with a fixed rate and equal monthly repayments. The owner can predict the payments for the whole term and plan her cash flow accordingly. There are no hidden conditions or surprise changes to the rate.
Example
A company treasurer is offered a currency hedge with a barrier that cancels the protection if the exchange rate moves too far. She asks for a plain vanilla forward contract instead. It costs a little more but gives certain protection.
Example
A pension fund buys plain vanilla government bonds to match its future payments to pensioners. The bonds are easy to value and trade at a very small cost. The fund can sell them quickly if it needs cash, which is important for paying benefits on time.
Formula
Calculation
Annual coupon = face value x coupon rate
A plain vanilla bond has a face value of $1,000,000 and pays a fixed coupon of 5% a year. The annual coupon is $1,000,000 x 5% = $50,000, paid until maturity.
If the bond has a 10-year life, the investor receives 10 x $50,000 = $500,000 in coupons. At maturity the issuer repays the face value of $1,000,000, so the investor's total cash received is $500,000 + $1,000,000 = $1,500,000.Case study
Seen in the real world.
Farrowdale Foods is a fictional food importer, and this case is illustrative. It needed to protect itself against a rise in the cost of a foreign currency, and its bank offered two products.
The first was a plain vanilla forward contract fixing the exchange rate for a $2,000,000 payment in six months. The second was a cheaper product that cancelled the protection if the rate moved beyond a trigger level, which saved the company about $20,000 up front.
The finance director chose the plain vanilla option, because the cheaper product would have left the company unprotected exactly when the currency moved sharply. The extra cost of $20,000 was 1% of the exposure. The illustrative lesson is that a simple product can be worth a higher price when its purpose is to give certainty.
Watch out
Common mistakes.
- Assuming plain vanilla means low risk, when even simple products can lose money.
- Buying a complex product without understanding how it behaves in a bad scenario.
- Thinking a vanilla product can never be customised, when terms such as amount, maturity and payment dates can still vary without turning it into an exotic product.
Questions
People also ask.
What is an exotic product?
It is a financial instrument with unusual features, such as conditions that switch it on or off.
Why do banks sell exotic products?
They can be tailored to a client's needs and may offer higher margins to the bank, which is why buyers should compare prices carefully.
Is plain vanilla always the best choice?
Not always, but it is usually the easiest to understand, price and exit.
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