Schweizer Armee Höhere Kaderausbildung der Armee Militärakademie an der ETH Zürich 1 1 Real Options: A Tool for Surge Decisions?* International Conference

Schweizer ArmeeHöhere Kaderausbildung der ArmeeMilitärakademie an der ETH Zürich

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Real Options: A Tool for Surge Decisions?*

International Conference on Operations Research„Mastering Complexity“, Munich 2010

Peter T. Baltes / Beat Suter, Swiss Military Academy at ETH Zurich

year 0 year 1 year 2

1* For their kind help the authors thank: Werner Epper, Walter Furter, Odilo Gwerder,Thomas Kuhn, Daniel Lätsch, Thomas Schaffner, Thomas Schlittler and Maximilian Zangger


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A simple military showcase

Situation and surge

Session OutlineSession Outline

Applicability and historical experiences

Wrap-up and further research

Why Real Options valuation


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Swiss situation – and solutionSwiss situation – and solution

End of Cold War: Peaceful and stable situation in Europe

Reduction of army size:

“Surge Cores” which know but can’t

Surge ≠ Mobilization

Surge ≠ Evolution or continuous build-up

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© www.armynavyairforce.co.uk


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Why Real Options Valuation – and how?Why Real Options Valuation – and how?

Expenses for armed forces as investment in security

Use of financial investment valuation methods Net present Value (NPV)?

Surge as an optional investment in security

Flexibility of investment Real Options

But… NPV does not account for flexible responseto changing security environment

Arbitration calculation between core units with surge optionversus “full grown” army


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A military showcaseA military showcase

Scenario„White Block“

Scenario„Black Block“

Protection of a conference – go in big or small?

Probability p Probability 1-p


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Parameters of the scenarios

Two threat scenarios and four defense (level) strategies

Stable situation after first day (of two)

A military showcaseA military showcase

No adaption costs

Insufficient defense is costly (just “d” instead of normal 1 gain)

Protection of a conference – go in big or small?


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Risky and cheapSafe and expensive

Flexible

Fixed

A military show caseA military show case

Protection of a conference – what’s the actual price of flexibility?

Strategy 3„Surge“

Strategy 4„Demobilization“

Strategy 1„Play it safe“

Strategy 2„Daring the gap“


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Strategy 1 – Play it safe

Expected Value = p·(1-k+1-k)+(1-p)·(1-k+1-k)

p

k k

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day 0

1-p

k k

1 1

day 1 day 2


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Strategy 3 – (Conditional) Surge

Expected Value = p·(1-k/2+1-k/2)+(1-p)·(d-k/2+1-k)

p

k/2 k/2

1 1

1-p

k/2 k

1d

day 0 day 1 day 2


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A most basic model - solvedA most basic model - solved

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kd

dp

p: Probability for scenario “White Block”d: Gain in case of insufficient protection (having small army in

case of “Black Block”, instead of gain 1 for sufficient protection)

k: Costs of large army, normalized to 1.k/2: Costs of small army, half of large army

When to prefer the surge to demobilisation?


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0,0 0,2 0,4 0,6 0,8 1k

d

p = 0,9

p = 0,8

p = 0,7

p = 0,6

p = 0,5

p = 0,3

0,0 0,2 0,4 0,6 0,8 1k

d

p = 0,9

p = 0,8

p = 0,7

p = 0,6

p = 0,5

p = 0,3

A graphical solution – p fixedA graphical solution – p fixed

Surge

p: Probability for scenario “White Block”d: Gain in case of insufficient protection (having small army in case of “Black Block”)k: Costs of large armyk/2: Costs of small army (half of large army)

Demobilization


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Surge is preferred, in case of…

low costs or casualties in case of failure

expected peaceful development

Summarized verballySummarized verbally

high costs for provision of security and troops


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Security situation development

Will to surge

Ability to surge

Pitfalls and corner stepsPitfalls and corner steps

??

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Switzerland

World War I

World War II

Track record of surgesTrack record of surges

Korea War

Foreign Countries before and during World War II

Great Britain

Finland

Germany


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Next steps and further researchNext steps and further research

• Scenario calculations and parameter estimation• Various input parameters• Modeling feature and depth variation• Cost-benefit calculation for case of surge without subsequent war

• Comparison with alternative modeling techniques• Calculations with different risk discount factors• Monte Carlo modeling

• Real Option values and structures flexible decision

• Real Options for different “markets”• Investment Capital market arbitrage• Security Comparative advantage arbitrage?

Documents

Schweizer Armee Höhere Kaderausbildung der Armee Militärakademie an der ETH Zürich 1 1 Real Options: A Tool for Surge Decisions?* International Conference