Transcript Real Options: A Tool for Surge Decisions?

Schweizer Armee
Höhere Kaderausbildung der Armee
Militärakademie an der ETH Zürich
Real Options: A Tool for Surge Decisions?*
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International Conference on Operations Research
„Mastering Complexity“, Munich 2010
Peter T. Baltes / Beat Suter, Swiss Military Academy at ETH Zurich
* 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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Session Outline
Schweizer Armee
Höhere Kaderausbildung der Armee
Militärakademie an der ETH Zürich
Situation and surge
Why Real Options valuation
A simple military showcase
Applicability and historical experiences
Wrap-up and further research
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Swiss situation – and solution
Schweizer Armee
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End of Cold War: Peaceful and stable situation in Europe
Reduction of army size:
“Surge Cores” which know but can’t
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Surge
≠
Mobilization
Surge
≠
Evolution or continuous build-up
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Why Real Options Valuation – and how?
Schweizer Armee
Höhere Kaderausbildung der Armee
Militärakademie an der ETH Zürich
Expenses for armed forces as investment in security
Use of financial investment valuation methods
 Net present Value (NPV)?
But… NPV does not account for flexible response
to changing security environment
Flexibility of investment  Real Options
Arbitration calculation between core units with surge option
versus “full grown” army
Surge as an optional investment in security
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A military showcase
Schweizer Armee
Höhere Kaderausbildung der Armee
Militärakademie an der ETH Zürich
Protection of a conference – go in big or small?
Scenario
„White Block“
Probability p
Scenario
„Black Block“
Probability 1-p
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A military showcase
Schweizer Armee
Höhere Kaderausbildung der Armee
Militärakademie an der ETH Zürich
Protection of a conference – go in big or small?
Parameters of the scenarios
Stable situation after first day (of two)
Two threat scenarios and four defense (level) strategies
No adaption costs
Insufficient defense is costly (just “d” instead of normal 1 gain)
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A military show case
Schweizer Armee
Höhere Kaderausbildung der Armee
Militärakademie an der ETH Zürich
Protection of a conference – what’s the actual price of flexibility?
Strategy 1
„Play it safe“
Strategy 4
„Demobilization“
Safe and expensive
Fixed
Strategy 2
„Daring the gap“
Flexible
Strategy 3
„Surge“
Risky and cheap
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A military show case
Strategy 1 – Play it safe
1
k
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Militärakademie an der ETH Zürich
1
k
p
Expected Value = p·(1-k+1-k)+(1-p)·(1-k+1-k)
1-p
day 0
k
k
1
1
day 1
day 2
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A military show case
Schweizer Armee
Höhere Kaderausbildung der Armee
Militärakademie an der ETH Zürich
Strategy 3 – (Conditional) Surge
1
k/2
1
k/2
p
Expected Value = p·(1-k/2+1-k/2)+(1-p)·(d-k/2+1-k)
1-p
day 0
k/2
k
d
1
day 1
day 2
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A most basic model - solved
Schweizer Armee
Höhere Kaderausbildung der Armee
Militärakademie an der ETH Zürich
When to prefer the surge to demobilisation?
p
p:
d:
k:
k/2:
1d k 2
1d
Probability for scenario “White Block”
Gain in case of insufficient protection (having small army in
case of “Black Block”, instead of gain 1 for sufficient protection)
Costs of large army, normalized to 1.
Costs of small army, half of large army
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A graphical solution – p fixed
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Militärakademie an der ETH Zürich
d
p
=
3
0,
p=
0,5
p=
0,6
p=
0,7
p=
0,8
p=
0,9
Surge
Demobilization
k
0,0
p:
d:
k:
k/2:
0,2
0,4
0,6
0,8
1
Probability for scenario “White Block”
Gain in case of insufficient protection (having small army in case of “Black Block”)
Costs of large army
Costs of small army (half of large army)
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Summarized verbally
Schweizer Armee
Höhere Kaderausbildung der Armee
Militärakademie an der ETH Zürich
Surge is preferred, in case of…
expected peaceful development
low costs or casualties in case of failure
high costs for provision of security and troops
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Pitfalls and corner steps
Security situation development
Schweizer Armee
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?
?
Will to surge
Ability to surge
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Track record of surges
Schweizer Armee
Höhere Kaderausbildung der Armee
Militärakademie an der ETH Zürich
Switzerland
World War I
World War II
Korea War
Foreign Countries before and during World War II
Great Britain
Finland
Germany
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Next steps and further research
Schweizer Armee
Höhere Kaderausbildung der Armee
Militärakademie an der ETH Zürich
•
Real Option values and structures flexible decision
•
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 Options for different “markets”
• Investment

Capital market arbitrage
• Security

Comparative advantage arbitrage?
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