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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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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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A military show caseA military show case
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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A military show caseA military show case
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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1
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?