Pricing Vanilla Options

Abstract

European equity options are financial instruments that provide the holder with the right, but not the obligation, to buy or sell an equity underlying at a pre-agreed price (the strike price) on a specified future date, the maturity date. It is the choice of the holder of the option to exercise their right to buy/sell the underlying at the strike price. The term “European” means that the exercise date may only take place on the option expiry date. European options can be standardized and exchange-traded or negotiated over the counter. The equity underlying could be a stock, a basket of stocks or a stock market index. Again, one can choose between physical and cash delivery at the inception of trade. Today, European options are widely traded by most market players, who are so used to their payoff mechanism that they call them vanilla financial products.