1. 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

2. 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

3. 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 ©
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 ©

4. 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

5. 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

6. 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

7. 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

8. 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

9. 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

10. 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

11. 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

12. 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

13. 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 © 13

14. 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

15. 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