Real Options: A Tool for Surge Decisions?* Höhere Kaderausbildung der Armee, MILAK Vortragsthema Anlass Real Options: A Tool for Surge Decisions?* year 0 year 1 year 2 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 1

Why Real Options valuation Session Outline Situation and surge Why Real Options valuation A simple military showcase Applicability and historical experiences Wrap-up and further research 2

Swiss situation – and solution End of Cold War: Peaceful and stable situation in Europe Reduction of army size: “Surge Cores” which know but can’t © www.armynavyairforce.co.uk Surge ≠ Mobilization Surge ≠ Evolution or continuous build-up Raise army size if necessity arises – the „how“ is left open „Sollte ein Aufwuchs der Armee einmal erforderlich sein, so wird die Art der konkret sich abzeichnenden Bedrohung entscheidend sein für Art, Umfang, Kosten und Dauer der zu treffenden Aufwuchsmassnahmen“ (Antwort des Bundesrats auf Interpellation Schlüer, 2009) Case study „DUHAFUCHS“ expects duration of more than six years and costs above 40 billion swiss francs for a surge – to double the size of the swiss army of 2006 © www.thediehards.co.uk

Why Real Options Valuation – and how? 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 An army costs and provides benefits: Basically it is an investment and should be measured with finance tools. Net Present Value reaches its limits at flexible decisions. „Real Option” Valuation is similar to Financial Option Valuation: Conditional (present-valued) income streams are value , e.g. by binomial trees (and risk-neutral backward-induction). Bases on arbitration calculation between the (Fixed) Underlying / “Benchmark” income streams versus (Conditional) “real” investment income streams.  The surge concept as a conditional investment in the security. Surge as an optional investment in security

Protection of a conference – go in big or small? A military showcase Protection of a conference – go in big or small? Scenario „White Block“ Scenario „Black Block“ Probability p Probability 1-p 5

Protection of a conference – go in big or small? A military showcase 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 Normal distribution of security environment development No evidence pro or contra: Can be adapted to fit personal belief Price taker & Perfect market (Swiss actions do not influence Security Situation) Small size of Switzerland No offensive capacity and will Remaining issue of disregarding effects of game theory: A weak opponent may „invite“ to use force. Path independence Assuming no further reduction below surge „cores“ there is no issue until „Point of surge“ No friction in option execution Politicians assume it works... Alternative: Model the fail risk. No adaption costs Insufficient defense is costly (just “d” instead of normal 1 gain) 6

Protection of a conference – what’s the actual price of flexibility? A military show case Protection of a conference – what’s the actual price of flexibility? Safe and expensive Risky and cheap Fixed Strategy 1 „Play it safe“ Strategy 2 „Daring the gap“ Flexible Strategy 4 „Demobilization“ Strategy 3 „Surge“ 7

Expected Value = p·(1-k+1-k)+(1-p)·(1-k+1-k) A military show case Strategy 1 – Play it safe 1 1 k k p Expected Value = p·(1-k+1-k)+(1-p)·(1-k+1-k) 1-p k k 1 1 day 0 day 1 day 2 8

Strategy 3 – (Conditional) Surge A military show case Strategy 3 – (Conditional) Surge 1 1 k/2 k/2 p Expected Value = p·(1-k/2+1-k/2)+(1-p)·(d-k/2+1-k) 1-p k/2 k d 1 day 0 day 1 day 2 9

When to prefer the surge to demobilisation? A most basic model - solved When to prefer the surge to demobilisation? 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 10

A graphical solution – p fixed Surge Demobilization 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 army k/2: Costs of small army (half of large army) 11

expected peaceful development Summarized verbally 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 12

Pitfalls and corner steps ? Security situation development ? Will to surge Security situation development Armies as stabilizing factor in international relations? Influence of Switzerland on direct threats? (Im)possibility of surprise? Will to surge Visionary politicians? Credibility of Intelligence Services and Armed Forces’ demands? Ability to surge Conservation of capabilities in small units? Surge ability on small basis feasible? Who sells which weapon systems in crisis? Ability to surge © www.phawker.com 13

Foreign Countries before and during World War II Track record of surges Switzerland World War I World War II Korea War Foreign Countries before and during World War II Great Britain Finland Germany 14

Next steps and further research 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 Modelling features: Surge failure probability american vs. European options fixed time need for surge Real Options for different “markets” Investment  Capital market arbitrage Security  Comparative advantage arbitrage? 15